Welcome to ECU's Investment Blog. This page is updated regularly to cover events impacting the global financial and currency markets.

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While the market continues to ruminate the troubles of the ‘three little PIIGS’ (most notably Greece), adding to the volatility and uncertainty of foreign exchange markets and interest rate expectations, the longer-term focus has switched back to the core underlying themes. The eurozone periphery will continue to garner column inches and official rhetoric for some time to come but global economic differentiation and the longer-term trends and dynamics of the global economy have come to the fore once more.

This morning’s data from the German IFO institute beat expectations for investor sentiment and current conditions, suggesting that there is potentially further to run in the impressive German recovery story. However, the expectations sub index declined for a third consecutive month, suggesting that firms expect significant headwinds to the recovery ahead.

The detail of the very impressive Q1 German GDP data was also released this morning and, while the rate of growth was maintained at +1.5% quarter on quarter, the breakdown of the data highlights a number of factors that boosted the quarterly data (capital investment +5.0% and construction investment +6.2%) that are unlikely to be sustained. While the retail sector of the economy remains upbeat about the prospects for growth going forward, export, manufacturing and service sectors are becoming less so.

In the UK, the new fiscal year saw public sector finances getting off to a disappointing start. While this is only one data point, the above-forecast deficit for April has brought the reality of the necessity for austerity back into focus for the UK. That said, the deficit for fiscal year 2010/11 came in (after revisions) at £139.4 billion, substantially below the OBR projections from March and the government spending cuts that should take hold for the rest of the year should impact positively on the data going forward.

In Japan, the cabinet office monthly economic report maintained its assessment of the economy saying that the economy shows ‘weakness’. In doing so, it lowered its evaluation of capital spending and cut its assessment of housing investment and profits.

Herein lies the dilemma. It is simple to find fault with the global economy at this stage of the recovery and there are concerns, albeit of different magnitudes and directions, for almost all major global economies. These include (but are by no means limited to) fiscal sustainability, sovereign debts woes, growth sustainability concerns, susceptibility of economies to overheating and sectoral growth bubbles.

In addition to this, the extreme volatility that we witnessed in the first few days of the current month emanating from silver and the commodity correction and spreading to a large position unwind in USD shorts and EUR long positions, has left a number of players with little or no room for manoeuvre and has added to subsequent volatility. What has ultimately turned into an ‘ugly contest’ in major FX has added to the uncertainty and, while I continue to envisage volatility over the remaining days of this month, I feel that a resumption of the bigger picture trends will take hold as we move into the last month of the first half of 2011. As the focus of attention comes back to the interest rate normalisation process in the eurozone (albeit with additions to the ‘separation principle’) at the start of June, we are likely to see USD’s ‘month in the sun’ coming to an end and, as this theme develops, I would expect JPY, which has been conspicuously quiet of late, to begin to weaken.

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The developments over the weekend have put eurozone woes back at the forefront of the market’s focus after S&P downgraded the outlook for Italian debt to Negative from Stable late on Friday evening. The Italians have shown their displeasure with the rating agency’s slight, saying that S&P’s views are very different from those of the IMF, OECD and EU but conceding that they will ‘intensify’ structural changes and push ahead with measures to balance the budget by 2014 and will submit adjustment measures to parliament by July.

The political backdrop for the eurozone has also added to concern for the region after the ruling Spanish socialist party suffered heavy defeats in the regional and local elections. As the disparity between the zone’s member states continues, political pressure on Germany (at the other end of the zone’s growth league table) has also grown.

Whilst the EU, ECB and IMF busily work behind the scenes to find a solution to the growing deficit concerns of Greece, rhetoric from the region’s officials continues to be aimed at containing fears of contagion to the ‘three little PIIGS’ (Portugal, Ireland and Greece). Whilst the weekend has potentially broadened the battleground for the containment of contagion to Italy and Spain (previously it was just Spain), the battle will still likely be won. The ‘big bad wolf’ of sovereign debt concerns is unlikely to have enough ‘huff and puff’ to blow Italy and Spain’s respective houses down.

While there are no concrete actions from the eurozone over the Greek issue, particularly with the increased rhetoric from the ECB that re-profiled or restructured debt will not be eligible as collateral for ECB borrowing (putting the Greek banking sector under further pressure), failure to act is increasingly being seen as a failure of political will and where there is no will, there is no way!

In the meantime, the ECB is likely to raise rates again next month as inflation in the zone continues to sit comfortably above the ECB mandate of ‘close to but below 2%’, While there are some signs that the growth momentum in the zone (and in the global export market) has slowed (visible in the eurozone PMI data this morning), the ECB has stuck to its mandate of delivering price stability to the eurozone and seems unwavered by the implications for growth from moderately higher interest rates.

In the UK the inflation versus growth debate continues to dominate. Many column inches over the weekend were discursive of the opinions of outgoing MPC member Andrew Sentance. The key point of the Sentance interviews was that he sees inflation staying high for a prolonged period and that it is likely to “stick around current levels”. BoE Chief Economist Spencer Dale appeared to place one foot into the hawkish camp on the MPC by stating over the weekend that he is “more worried about inflation than recovery”. While Dale conceded that he is still not confident that the recovery has taken hold, his view that “persistent inflation is worse than raising rates” goes some way towards bridging the hawkish deficit left behind by Andrew Sentance.

The current market dynamic, however, has risk and the eurozone troubles at its core and thus the argument for higher rates in the UK will likely be a focus for another day. I have expressed my views about the MPC and the need for them to take action  many times on this blog but, for now, with minimal direct market positioning in GBP, strength will likely continue first versus EUR and develop into a broader strength once the adjustment to the current eurozone concern has played out in a market that is still short of USD and long of EUR.

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“Temporary solutions often become permanent problems.”

Craig Bruce

Comments from various speakers gave the market some food for thought yesterday, most notably comments from BoE Deputy Governor Charles Bean and New York Federal Reserve president William Dudley.  Both expressed very different focal points in their discussions of Monetary Policy concerns in the current, uncertain inflation / growth environment for the global and national economies.

Charles Bean highlighted the impact of sterling’s declines over the past couple of years and that its current low level should act as a stimulus to the economy and economic rebalancing.  Bean also reiterated the core drivers of current price pressures being the effects of VAT, GBP and the oil price.  In highlighting that there is considerable uncertainty surrounding the CPI forecasts at the current juncture and warning that higher inflation may lead to higher pay demands, his core message was that the BoE had chosen to accept the ‘temporary’ above target inflation.

History may be a much harsher judge of Beans use of the word ‘temporary’ in years to come.  I have previously discussed the risk of fuelling asset price bubbles in the UK with a hugely accommodative monetary policy and this is again highlighted by a central bank, who is mandated to maintain consumer prices at a 2% target, referring to the fact that “temporary, above target inflation doesn’t conflict with the mandate”, when inflation has been beyond the upper bound for the inflation target since December 2009.

In the US, Dudley, considered one of the three core sages on the FOMC, also kept his dovish leanings in relation to US monetary policy in suggesting that with “core inflation below levels consistent with the mandate” and unemployment levels “unacceptably high”, there remains a “considerable way before the fed meets its dual mandate”.

It is an important point that the Fed inflation emphasis remains focussed on core inflation as a means to ‘look through’ the temporary effects of energy price impacts on prices.  The UK on the other hand seem more reliant on, or committed to the view, that a sharp slowdown in consumer spending (as real incomes fall and disposable income is squeezed) will bring down inflation significantly in 2012.  As I see it the pressure on the interest rate differential between the US and the UK should start to grow as US monetary normalisation will significantly lag that of the UK, despite reticence of the MPC to act at this juncture.

On a valuation point after the sharp decline in the EUR over the past couple of weeks I think that market will become increasingly focussed on value and economic growth potential (and by default interest rate hike potential) from this point.  Following on from the very disappointing Japanese growth data for the end of 2010 and start of 2011 concerns over the Japanese economy will likely increase and JPY should suffer.  Comments from the Swiss National Bank that the “Government, SNB may take appropriate FX measures” also gives an idea of the level of discomfort some economies are being exposed to as a result of the FX dislocation of recent years.  CHF is not only very overvalued but the positional overhang is also large.

In conjunction with my core views on the USD, I feel there is significant value in the ‘crosses’ from here and buying GBP and EUR vs. CHF and JPY seem to me to be the standout value trades for coming weeks.

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The Japanese Q1 2011 GDP release overnight highlighted the scale of the mountain that Japan has to climb in order to return to sustainable growth. The data, which will clearly have been impacted by the earthquake and subsequent tsunami (but not to the extent that we expect for Q2 and possibly Q3, before growth starts to return), pointed to an annualised decline in activity of 3.7% – far worse than had been expected. Perhaps the most concerning element, however, was the downward revision to the Q4 data, unaffected by the earthquake but highlighting the fragility of the economy ahead of the disaster.

The broad financial markets has, up until now, had the consensus view that the terrible events of March will have temporary impact and that the benefits to the economy of the rebuilding and stimulus packages will induce a ‘V’ shaped recovery. Concerns from BoJ board members (that further falls in consumer confidence risk a downward negative spiral against which they would have no effective defence) and PM Kan’s acknowledgement yesterday that Japan “must consider a second disaster relief plan if the first is insufficient”, highlight the growing concern over the medium-term growth prospects of the worlds third largest economy.

The positive impact of the construction expenditure will be partly offset by tax increases and other cuts in government expenditure, and further stimulus packages (as a result of consumer weakness) will bring the possibility of monetisation of Japanese government debt back to the forefront of rhetoric and debate.

One thing that stands out from the concerns over Japan, particularly in light of a moderation in the pace of the global economic growth and export demand, is the level of JPY. For the past couple of weeks, JPY has been very quietly sitting at its highs. Over the next couple of weeks I think that market realisation of the level of overvaluation, combined with the refinement of the market view of the shape of economic recovery from ‘V’ to ‘U’ or even ‘L’, will lead to a decline in the value of JPY at an increasing pace.

Speaking of imminent declines in the value of a nation’s currency, last night’s FOMC meeting minutes from the 26/27 April meeting went into great detail about the tools the Fed has at its disposal and the manner in which such tools should be deployed in activating the process of monetary normalisation. Almost all members suggested that they favoured ceasing MBS reinvestment as the first step in the process of monetary tightening (probably likely to come at the same time as the removal of the “extended period” language.)

However, the modus operandi of the Fed in tightening monetary policy is currently merely an intellectual debate. Despite suggestions from a couple of hawks on the FOMC that rates could be raised as early as the end of this year, the majority, including Chairman Bernanke and Vice Chair Yellen, are considerably more dovish.

It is very likely that real rates will remain significantly negative in the US for some time, and, as the US and Japan lag the rest of the world in the rate normalisation cycle, USD and JPY are likely to suffer.

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This morning’s release of the May minutes from the Bank of England’s monetary policy meeting put GBP at the forefront of activity once again. Policy members maintained the Bank rate at 0.50% in May with a 6-3 vote. Of the three dissenters; Spencer Dale and Martin Weale both favoured a 25bp hike, though both suggested that “the case for a rate hike is finely balanced”. The outgoing Andrew Sentance maintained his call for a more aggressive 50bp hike and all three dissenters offered the view that they saw “little benefit in waiting”.

The MPC’s ‘wait and see’ camp still appears to be restrained from action by the potential threat of consumer weakness and the fact that the current level of inflation is yet to feed into expectations or wage demands. The comfort that the MPC may have felt during the May meeting – that inflation had calmed from the March data – has subsequently been unwound by the 4.5% CPI print yesterday. Yesterday’s blog discussed this. However, perhaps the most pertinent focus from a UK monetary policy standpoint should be the influence of incoming member Ben Broadbent, and at which end of the table he pulls up a seat at his first meeting in June.

Labour market data in the UK this morning brought more mixed news on the growth momentum of the economy. While the claimant count measure indicated a slight uptick in both claims and the unemployment rate, the broader ILO measure showed the unemployment rate for Q1 falling to 7.7%. Headline wage growth, including bonus payments, increased on the month to 2.3% but this is still firmly negative in real terms and unlikely to turn the heads of the ‘wait and see’ camp on the MPC.

Risk aversion in financial markets seems to have calmed a touch overnight, despite the announcement by Moody’s that they are downgrading Australia’s four major banks (though this only brings Moody’s ratings into line with other major credit rating agencies). In foreign exchange markets, this has seen a stabilisation of the USD ascent (albeit in a period of very poor liquidity) and, despite the uncertainty surrounding the fiscal and sovereign debt outlook for Greece, for me, the unwind of long EUR (short USD) positioning now provides a platform for the market to resume the underlying core trend – USD devaluation.

Greek concerns will continue to reverberate for a while longer as rhetoric and conjecture about the correct way to deal with the fiscal situation are mooted. However, it may well be the fiscal concerns of the US that will be the spark to the resumption of the USD downtrend. Treasury secretary Timothy Geithner stated last night that the “US must address pressing fiscal problems” as the US reached its debt limit. A bi-partisan agreement on the raising of the debt limit is yet to be agreed and, while they must act before 1 August, concern is likely to grow just as the eurozone puts its house in order over Greece. Geithner’s statement that the “republicans may cause the first default in US history may be just sabre rattling but, with no likelihood of higher US rates in the near term, the “exceptionally low for an extended period” language from the Fed may be applied to USD as well as US interest rates.

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Yesterday’s European Ecofin meeting produced a number of statements, all of which were broadly expected. There were no decisions or announcements on a plan for Greece. It was suggested that a decision will be made by the next Eurogroup meeting on 20 June and that the ‘solution’ would require further commitments (and political unity) on privatisation and additional deficit cutting measures. Portugal, however, saw their aid package (€78 billion) unanimously ratified.

The Greek restructuring rumours and rhetoric continue to reverberate around the market with Eurogroup’s Juncker apparently remaining an advocate, though through his choice of language he has tried to mute the negative implications of a restructuring (which would be classified as a ‘credit event’) towards ‘re-profiling’ or even a ‘soft restructuring’. The announcement that a decision will not be made until 20 June has, however, damped the immediate impact of the fear of restructuring. Indeed, after the significant devaluation of EUR, largely at the benefit of USD over the last couple of weeks, we are now seeing some signs of stability, and thoughts of relative value and relative interest rate differentials are beginning to emerge as position adjustment reaches a plateau.

The major data focus today has been in the UK and the inflation data for April. As I suggested yesterday, consumer prices bounced back sharply in April (influenced strongly by the timing of Easter) with prices matching the record rise for a month and reaching the highest headline level since October 2008. Inflation is likely to rise to 5% over the coming months and the “best guess” of the MPC’s newest member, Ben Broadbent, that “inflation will come down”, the inflation-fighting credibility of the BoE’s policy board will continue to be questioned over coming months, joined by the possibility that the BoE is fuelling potential asset bubbles for the future.

Indeed, the market may soon start to dictate a faster pace of rate rises if consumer prices continue to grind higher while the MPC forecasts continue to remain reliant on a weak consumer over the remainder of this year to bring inflation slowly back to target. Five-year break-even inflation rates in the UK have started to edge higher and it is only the lack of wage price pressures that is giving the MPC solace in their ‘wait and see’ formation. With strong negative growth expectations priced into GBP, there is an upside skew to the balance of risks to GBP over the rest of this year and, in current markets, we would favour the greatest movements being against the currencies against which GBP is most undervalued. At the current juncture, we view these to be JPY and CHF.

The Governor of the Bank of England, Mervyn King, in his letter to the Chancellor of the Exchequer (to explain the (in)actions of the BoE that have enabled a CPI print above the 3% target band) suggested that it is VAT, energy and import prices that are driving inflation and that, “without these factors, CPI may be below target”. This may well be the case but, without such factors as ‘not scoring enough goals’, West Ham United may still be in the Premiership. The reality, much to my chagrin, is that these factors do exist and, in my view, GBP and UK interest rates remain cheap.

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Last week closed with a continued sentiment focus on commodity price developments and the positional adjustments that have been induced across all asset classes. However, the macroeconomic focus was on the US, as inflation data took centre stage on Friday. The headline rate rose to a two and a half year high of 3.2% in April but the core rate remained stable at a level which is unlikely to concern US monetary policymakers in the short term and, with commodity prices having fallen dramatically in May, the upward price pressures are likely to moderate over coming months.

Today’s macroeconomic and sentiment focus is back with the eurozone as the Ecofin meeting, originally scheduled to firm up the aid package to Portugal (€78 billion) and potentially agree concessions for Ireland, will likely be dominated by the increased urgency with which the eurozone needs to come up with a solution to the fiscal woes of Greece.

The Q1 GDP data from the eurozone last week showed that 2011 got off to a solid start in terms of economic growth. However, the detail of the data highlighted that growth is becoming increasingly driven by the core countries (although rising domestic demand in the core may eventually boost exports from the periphery) and divergences across the zone are widening. The official data showed Portugal officially slipping back into recession, with a second consecutive quarterly decline in growth highlighting the urgency of the aid package. While the meeting is unlikely to reveal any formal measures for a proposed solution to the increased Greek fiscal concerns, the post-meeting rhetoric is likely to suggest that a comprehensive panacea is at hand.

Tomorrow, the focus is likely to head back to the UK as inflation data once more takes centre stage. The unexpectedly large fall back in the headline rate in February, back in line with the Bank of England’s central projection, was the trigger for a sharp sell-off in interest rate hike expectations and GBP. The risks to the April data are to the topside as commodities and energy held the highs in April before the May sell-off. The impact of a higher inflation print, however, is more of a moot point as the debate over the sustainability of the recent sell-off (or unsustainability of previous highs) dominates.

Staying with the UK, the BoE minutes from the May policy meeting will be significant as a barometer of the sentiment of the MPC towards an inflation threat that has been ‘downgraded’ by financial markets. Also significant following on from the minutes is the fact that ‘uber’ hawk Andrew Sentance departs the committee this month to be replaced by Ben Broadbent and, as such, the aggregate bias of the MPC is likely to have a moderate shift back towards the central ‘wait and see’ camp, led by the Governor.

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The euro gained across the board this morning as German and French economic growth surged in the first quarter, thereby fuelling the case for further interest-rate increases by the European Central Bank. German gross domestic product jumped 1.5% and the French economy grew 1%, exceeding economists’ median expectations of 0.9% and 0.6% respectively. The market is now pricing in some 95 basis points of interest rate hikes over the next 12 months, up from 71 basis points of tightening predicted at the beginning of the week. Given very real concerns over debt issues surrounding peripheral countries (notably Greece, Portugal and Ireland), market expectations here may well be somewhat ahead of themselves. More importantly, we view the pace of growth as portrayed by today’s data to be more of a temporary blip and, given very clear signs of moderating/falling demand elsewhere, not an indication of greater things to come.

The yen advanced as Japanese Economy and Fiscal Policy Minister Kaoru Yosano said the currency’s strength was a result of the dollar weakening, not the yen gaining independently. The yen was also boosted by speculation that Tokyo Electric Power Co. is repatriating overseas funds to pay for damages and compensation in the wake of this year’s nuclear power-plant disaster. Chief Cabinet Secretary Yukio Edano yesterday said compensation will amount to “trillions of yen”. However, these comments need to be put into context with official statements made by G7, G20 and Japanese Finance Ministers and the Japanese Prime Minister, all of whom have clearly stated their commitment to avoid the economically and financially degenerative consequences of continuing yen strength. Indeed, the 15 April G20 communiqué could not have been more definitive. It stated that the G20 finance ministers had agreed to strengthen co-ordination “to avoid disorderly movements and persistent exchange rate misalignments”. It also expressed their solidarity with the Japanese people after the tragic events and confirmed their “readiness to provide any needed co-operation”.

The Bank of Japan Governor, Masaaki Shirakawa, reaffirmed his country’s position in adding, “we will continue strong support of the economy and financial markets”. The closely knit correlation over the years between the strength of the yen and its negative impact on the Japanese economy and financial markets is well rooted. Accordingly, especially with the yen’s trade-weighted index now at its highest level since co-ordinated G7 intervention to weaken the yen on 18 March, it remains our view that the risks of further intervention remain a clear and present danger.

Of greater immediate importance to currency markets generally at this juncture is the outlook for commodity prices. We have seen extensive volatility here with silver prices tumbling an eye-popping 35% over the past three weeks. With oil having reeled back some 17.5% over the same period and other commodities well off their highs, we see this sector as being extremely vulnerable to further sizable corrections to the downside if the recent lows are revisited and taken out. This can be all too clear to see by looking at the medium-term (click here) and long-term charts (click here) of the CRB Index. In short, this is where considerable speculative flows have been directed over recent months/years and where (as we saw in 2008) there is the potential for “panic selling” given the extent of long speculative holdings.

Should another wave of selling in the commodity sector ensue, it is also clear that this will have a material (and negative) impact on correlated currencies like the Australian dollar (click here) which have also been the target of sizable speculative and leveraged inflows. In such an unwinding in positioning, were we to see this, the US dollar would certainly benefit markedly against the higher-yielding Emerging Market, European and commodity-based currencies as the broad sell-off in commodities creates a domino effect into FX.

On the data front, this afternoon’s CPI data and the University of Michigan Confidence numbers in the US will be relevant to the outlook for US interest rates and, by implication, the aforementioned debate on commodities, equities and FX.

Have a good weekend.

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All that glisters at the moment is certainly not silver. In fact, it has been the silver market that has seen the greatest degree of volatility in the recent commodity sell-off and the asset which should be currently viewed as the barometer for risk sentiment and a proxy for the positional overhang that is causing widespread capitulation across all asset classes.

However, while there is still a great deal of potential for silver and some of the other commodity markets to see continued capitulation and position unwinding, driving prices down further, the situation in the currency markets will likely take on a different dynamic soon.

The broad sell-off in risk assets that we have seen over the last six business days has seen EURUSD drop by over 5% and, while this is modest in comparison to the decline of silver which has moved almost ten times as much, it has caused a lot of discomfort to a market that had finally got itself comfortable with selling USD from a fundamental and technical perspective, only to see a sharp reversal as risk aversion grew. EUR, however, is likely coming into good value territory and I would expect that we are not too far from the end of the recent sell-off as commodity correlations break down.

With half an eye on the developments of metal and oil prices this afternoon, the US data will be of particular focus. Retail sales will give us another snapshot of US consumer activity in the light of last month’s improvement in the labour market. However, the producer price data will likely take the headlines as the US inflation debate takes hold ahead of the consumer price data tomorrow.

I feel that the foreign exchange market is likely to take on a slightly different dynamic from these levels. EUR, while still vulnerable to a further capitulative sell-off in the short term, is nearing value levels. Any signs of inflationary pressures in the US over the next couple of days will support interest rate expectations in the US and should underpin USDJPY. In short, I feel that the market will move away from the blind ‘risk off’ (position off) dynamic and will become more focussed on the implications of the current volatility and resultant market levels for growth and interest rate expectations. Commodities are likely to continue to remain fragile and biased to further unwinds over the near term and that will likely leave the commodity currencies (AUD, CAD, NZD) vulnerable to further downside.

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The focus of the day so far has been squarely on the UK, initially from a trade perspective and subsequently – and perhaps most importantly – on the Bank of England Quarterly Inflation Report (QIR).

Official figures this morning suggested that, after two months of sharp narrowing of the trade deficit in the UK, the deficit widened slightly in March. The goods deficit for March widened to £7.7 billion (down from approximately £10 billion at the end of 2010). However, an improvement in the services balance meant that the total trade deficit widened by a minimal amount to £3.3 billion. Indeed, net trade looks set to improve further over coming months as a potentially constrained consumer damps import demand while the survey evidence suggests exports will continue to show strength.

The QIR brought the market’s attention to the broader macroeconomic position of the UK (net trade is a relatively small component of GDP). Going into the release, the market had expressed a clear negative bias to the prospect of the inflation report following weaker-than-expected growth in Q1 and recent examples of further consumer weakness (albeit, in my view, temporary and Easter-timing impacted). In reality, however, the content of the inflation report was more hawkish (or perhaps – more correctly – less dovish) than expected.

BoE Governor King highlighted a “roughly equal chance that CPI is above or below target in the medium term” with a good chance inflation reaches 5% this year. He went on to admit that rates will have to be normalised at some point, yet the current level of volatility in prices and greater-than-usual economic uncertainties make the timing of the rate normalisation path more difficult to predict. Further, the official forecasts suggest that, assuming the market implied path of rates (currently ‘Bank Rate’ at 0.75% by Q4 2011 and 1.75% by Q4 2012), the central projection is at target at the forecast horizon. This is a further reminder to the market that interest rates at such accommodative levels are temporary phenomena, and projections such as this should support the longer-term dynamic of GBP at such undervalued levels.

On the growth front, the report continues to outline the uncertainties and risks to consumer spending and that the growth outlook is weaker than in February. However, the report concedes that “survey evidence suggests that underlying GDP growth is stronger than the official figures” and that “the pace of growth is likely to pick up from the ‘soft patch’”.

In the shorter term, today’s data do little to change the underlying dynamic. GBP should be better supported in general and those with a longer-term mandate may now begin to focus on the substantial relative value in GBP on a number of crosses. However, for the moment, the market will retain its data focus as the predominant driver of sentiment and positioning. Next stop on this front is the US trade balance this afternoon.

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The ongoing debate over the Greek sovereign debt and fiscal deficits continue to dominate the broader financial markets. Speculation and rumour is abundant and has added to volatility in a period where conviction is low and liquidity is at a premium.

Friday afternoon’s speculative conjecture from a German newspaper that Greece was considering an exit from the euro pressed on the worst fears of a market that was under pressure from a correction in USD following on from a stronger-than-expected employment report. While in reality the likelihood of Greece exiting the euro at this juncture is extremely remote (and the likelihood of pre-announcing such a move, even more so), the ‘unknown unknown’ that this added to the dynamic, further aided position squaring and fuelled EUR selling.

This morning the rumour mill has been actively blowing hot air once more with earlier talk of a new Greek aid package deal (possibly for as early as June) which was later denied, and further suggestion from a German MP that the criteria for the release of the next tranche of Greek aid may not be met.

In my view, the reality of the situation is that the eurozone as a whole has “no alternative to more help for Greece” (Merkel ally comments over the weekend). However, in doing so, it is imperative that the measures that the authorities decide on must be sufficient not only to bring Greece back to a situation of fiscal sustainability (with the ability to return to the markets to access funds over a reasonable time frame), BUT they must also ensure that the measures are such that they do not in any way shift the burden, or focus of market attention, onto the ‘next weakest’ of the periphery states, as has been the case with many previous measures.

In the UK, the news overnight struck a more positive tone with BRC like-for-like sales rebounding strongly in April as Easter, the royal wedding bank holiday and the record April weather drove consumer activity. The RICS house price balance also showed further improvement as supply constraints continue to support the housing market.

Despite a more positive global economic backdrop this week, ‘risk assets’ have failed to make any real headway as the volatility of the end of last week and the uncertainty surrounding the next steps for Greece continue to leave market participants on the sidelines. In this environment, the economic data will continue to have an exaggerated impact on foreign exchange rates as the data give credibility to one side of the market and investor funds are drawn in. For the rest of the week, the Bank of England Quarterly Inflation Report tomorrow will be of particular importance for guiding interest rate expectations in the UK, and German Q1 GDP along with retail and inflation data from the US provide the other core highlights.

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The much awaited US employment report on Friday brought a halt to the disappointing economic data of late, showing an above-consensus job creation number with the highest private payroll increase since February 2006. The positivity of the payroll data was tempered, however, by the rise in the labour force (a long-term positive for growth potential) which took the current unemployment rate back up to the 9% level.

Whilst the short-term impact of the jobs data was a positive for USD, the events of the afternoon were subsequently dominated by news, rumour and speculation out of the eurozone. The revelation from a German newspaper website that “Greece considers exit from the eurozone” caused widespread panic in financial markets and the ensuing volatility saw EUR sold aggressively.

In reality, the conjecture of a Greek eurozone exit derived from a meeting in Luxembourg to discuss the Greek fiscal programme. The Greek government has subsequently issued a statement that “participation in the eurozone was not raised or discussed”, and that Greece is “firmly committed to the agreed economic programme.”

Despite the protestations by the Greek government (and the entirety of the EU and eurozone officialdom) that there will be no debt restructuring, default or exit from the strict fiscal targets (or the eurozone itself), the developments in global market concern over the future path of Greece is not entirely unwarranted. It is likely that over coming months there will be some form of concession to the difficulties of Greece, most likely in the form of lower rates or extended maturities on the bailout loans from the EU and IMF. In essence, there is “no alternative” to more help for Greece.

So where does this leave us now? The past week was one of extreme volatility, most notably in commodities, but significantly in equity, bond and foreign exchange markets. The main effect of the volatility was to induce position squaring as the market took risk off the table, and this worked to the benefit of USD and to the detriment of commodities, interest rate expectations and equities.

However, as we enter the new week we have already witnessed a decent bounce back in oil and commodity prices and, while USD has failed to give back any significant proportion of its gains, the interest rate and relative fundamentals of the US still leave it on the back foot in the medium term. It would be a mistake to view the sell-off of last week as a sign that commodity prices are now headed lower and that global inflationary pressures will now dissipate.

In this regard, the UK inflation report will be keenly viewed this week, the forecasts of which form the fundamental basis of the policy decisions of the Bank of England. In the eurozone, despite the well-publicised concerns of the periphery, German trade data this morning highlighted exports at the highest monthly value ever recorded and, with interest rate expectations in the eurozone pared back dramatically after less hawkish than expected rhetoric from ECB president Trichet last week, this highlight of the continued momentum in the core eurozone countries may be enough to put a base on interest rate expectations at their current lower levels.

This week is a very important juncture in the medium-term dynamic of financial markets and, as we pointed out last week, the macroeconomic data will form greater importance in the market dynamic as confidence of view and opinion is rebuilt after the volatility of last week.

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As we began the trading day yesterday, the prevailing themes within the broader financial markets were well established. Commodity prices had begun to show signs of exhaustion, lead by silver which plummeted on the (holiday-thinned) market open to the week after trading margins were raised on the global exchanges. As positions that had been built up over a long period of appreciation began to unwind at an accelerating rate, risk aversion spread across broader asset classes.

While the fall in silver (and other metals) will have gained the majority of column inches in this morning’s press (with a nice round 25% fall this week), it is the fall in crude oil prices that has the greatest bearing on the global economic backdrop, not just on the potential impact for global economic growth. But perhaps more importantly at this juncture, its impact on the monetary policy implications of changes to global inflation and interest rate expectations needs to be considered.

UK data this morning highlighted these issues as producer prices for April came in above expectations and once more outlined the issue of UK inflation. The caveat to this, however, following on from the recent slide in the oil price is that the April producer price data was benchmarked at the peak of the oil price. Recent days’ activity has seen a decline in the oil price of around $20 per barrel, or enough to take 2% off producer prices in May, should the fall prove to be sustained.

The focus on monetary policy and a renewed focus on the growth/inflation trade-off was a core theme of yesterday. As the day progressed, the key focal point was the scheduled press conference from the ECB. Suggesting that the market had taken its eye off the ball is probably a bit harsh, but expectations over the pace of ECB tightening had been steadily rising over the last few months after the ECB raised rates from the historic low of 1.00% in April and, despite the continued woes of the periphery, the core focus of the market’s attention was on whether Trichet would signal a June or July follow up interest rate rise.

In the event, ECB president Trichet’s broad rhetoric surprised the markets by expressing caution over the global growth outlook. Whilst he stated that “the stance of monetary policy remains accommodative” and that “underlying economic momentum remains positive” in the light of position unwinding in other asset classes, his effective signal that the next hike will likely come in July (and not June) disappointed a market that was long of EUR and caused a re-evaluation of the interest rate hiking cycle.

This re-evaluation saw EUR sharply lower on the day and, in terms of interest rate expectations over the course of the next 12 months, the market now has three 25bp hikes priced in as opposed to four before the conference.

Whilst we don’t advocate a long-term reversal in the fortunes of EUR at this point, or perhaps more pertinently a reversal in the fortunes of USD, we are likely in for a short period of further consolidation where the macroeconomic data will have an exaggerated impact on interest and FX rates. The impact on inflation expectations, monetary policy and consumer confidence from the fall in the oil price will be actively mooted by market participants over the next few days and the price action in oil as well as other ‘risk assets’ will be key to driving sentiment and the resumption of trends.

As I have stated above, the key driver in the near term will be macroeconomic data, and this afternoon we get arguably the most important piece of macro data on the economic calendar: the US employment report. Consensus is fairly well aligned to a 175k rise in payrolls for the month of April. A stronger than consensus number is likely to see a further unwinding of USD shorts as the market takes a further back seat from USD selling. However, a weaker number is not necessarily as clear cut. A very weak number could potentially spark risk aversion in the current nervous climate, and this may also result in USD buying in the short term. For me, however, the bigger picture has not changed, and USD will likely continue its decline (against those currencies whose central banks are minded to raise rates) before too long.

Have a great weekend.

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Over the last few trading sessions, the risk profile of the financial markets has deteriorated. Weak business sentiment survey data across the globe was extended further yesterday with the inclusion of the eurozone and US, and this morning with the UK service sector data. The surveys suggest that we are in for a period of slightly slower global growth as a large number of global economies brace for the economic reality of fiscal austerity.  This morning’s shockingly weak German factory orders data is another sign that the near term environment is less favourable for global growth.

It is the weaker (global) macroeconomic data that has given the broader market cause to step back and rein in ‘risk’ or exposure, while also coming to terms with the reality of weaker US growth and a structurally weak USD. What the market has not yet mooted is the possibility that the US economic weakness is maintained and what the impact of this will be for broader risk assets and, indeed, for USD.

For the near term, however, the recent data is more likely to cause increased volatility than a sharp turnaround in the recent trends – predominantly USD weakness. In this regard, the market will be intensely focused on the US employment report on Friday and, despite the recent rhetoric from Fed members that they are now expecting payrolls to rise at 200k per month for the rest of 2011, the US has a long way to go before it can begin to remove the current level of monetary accommodation.

This afternoon’s ECB press conference is likely to be important for the near-term sustainability of the current level of EUR, considering market positioning and the recent rises in both risk aversion and volatility. As is often the case at this stage of the hiking cycle, the market will be forensically attentive to the composition of the statement in order to gauge the likely timing of the next hike. The market is currently pricing in June and then September as the likely timing of the next interest rate hikes, and any hint of caution from Trichet will likely lead to further long EUR (and risk asset) position unwinding.

The remainder of this week will likely provide significant opportunity as the market jostles for position into (and indeed as a result of) the US employment report. Weekly claims data this afternoon will likely be watched but will not provide any information ahead of tomorrow’s report.

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After a fairly quiet overnight session, muted by the Japanese Golden Week holidays, today has got off to a fairly eventful start. April eurozone service sector PMI data was revised lower from the initial ‘flash’ estimates and the composite eurozone retail sales data was very disappointing, showing a drop of 1.7% year on year.

However (and in contrast to the high frequency economic data), the news that Portugal has agreed a bailout package with the EU and IMF totalling €78 billion over three years has been met with initial approval from the bond markets as the yield demanded to hold Portuguese sovereign debt has moderated. The detail of the Portuguese package seems a touch less draconian than the criteria attached to the Greek and Irish aid packages and, indeed, the fiscal consolidation agreed over the three-year term (and beyond) falls short of the measures proposed by the Portuguese government prior to the parliamentary rejection.

In the UK, the recent run of weaker-than-expected data continued with construction sector PMI data that disappointed market expectations. Lending data also came in on the soft side, highlighting the continued fragility of the housing sector and likely increased prudence of the consumer. The important test for GBP and the UK will come tomorrow, however, when the service sector PMI data is released. The service sector accounts for over 70% of UK GDP and any significant deterioration in this measure will likely dent GBP’s fortunes further.

On a longer-term basis, however, GBP is still very undervalued, and comments this morning from both ex-Bank of England policy maker John Gieve and S&P that the start of the rate normalisation process is likely to be within the next few months, may well bring the focus back towards the longer-term relative value of GBP, particularly vs those currencies where rates are more clearly on hold for longer (e.g., USD and JPY).

This afternoon private sector payroll data from the US is released and, while the correlation between the ADP report and the official unemployment report on Friday has not been strong of late, the data will keep the market’s attention firmly on Friday’s release, and, in broader terms, on USD.

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After another very long weekend in the UK the markets have returned this morning to see that USD has made another new low with AUD reaching the heady heights of 1.1000 and CHF reaching new record highs. The USD down trend is now firmly engrained and, despite the decent bounce that USD has enjoyed in the early trading session today, 12-month Treasury Bill yields have hit a new record low at 0.173%. We may be headed for more two-way volatility over the coming weeks, but the main drivers for the USD slide are still intact. USD remains the funding currency of choice and will continue to struggle.

Elsewhere, this morning’s UK data showed some weakness in April as the pace of the manufacturing recovery slowed to a seven month low, partly reflecting a fall in the output balance. There is some suggestion that the Japanese supply disruptions may have played a part in the recent slowdown, but manufacturing is still firmly in expansionary territory and, as the strength of manufacturing data from other nations over the past couple of days suggest, the sector continues to expand on a global basis and the UK’s manufacturing sector will likely bounce back, particularly in comparison to the UK’s main trading partners (the eurozone), where UK manufactured goods are very cheap.

In the eurozone, the yield spreads between the core and the periphery continue to widen and, as long as Spanish bonds continue to retain strong demand (at least relative to the periphery), EUR will continue to benefit, particularly vs the beleaguered USD. Interest rate expectations continue to grow in the eurozone and with Trichet on the wires over the weekend suggesting that the ECB will “keep rate policy separate from non-standard measures”, the ‘separation principle’ of the ECB will likely facilitate a further rate hike at next month’s meeting. The phrase ‘strong vigilance’ (used by the ECB president in this week’s rate meeting statement) is likely to be taken as a signal of a 25bp hike at the June meeting.

Until the CPI data release for March, the Bank of England’s May meeting was viewed as the likely start of the UK’s rate normalisation process. The weaker inflation pressure and subsequent raft of disappointing consumer data (arguably largely due to the timing of Easter) has put market expectations back. The central driver for the timing of the first UK rate hike is now the Quarterly Inflation Report in November.

While we are clearly in a trending environment across a number of financial markets, silver provided an important warning to markets that the trend is not always your friend, as the authorities lifted the margin requirements on silver futures which caused a 13% fall in the commodity yesterday. As a consequence, the market seems to be approaching the start of the month with a much more cautious approach and, with the all important US employment report at the end of this week, some further short USD position liquidation is possible leading up to the data release. However, I still feel that we should be using any bid in USD as an opportunity to sell. We are still some way off a true USD recovery.

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