Sterling shines for second week on a row as euro downtrend continues

Tom Tong23/Jul/2012Currency Updates

Sterling rose against most major currencies last week. Most macroeconomic and FX trends from the previous week continued into this one. Weak data worldwide painted a worrisome picture of synchronized weakness among the major economies. The European disaster got worse, as sovereign yields in Spain hit new all time records and policymakers were unable or unwilling to respond to the worsening crisis. The euro continued its trend lower in spite of the record short positioning among investors and traders. Away from FX markets, equities managed to eke out another modest rally, as the unattractiveness of cash at zero yields and safe bonds at all time records outweighed investors’ worries about Europe and the slowing world economy.

GBP

The Bank of England minutes and the CPI release last week provided further support to our view that the MPC is likely to surprise on the dovish side. Although the vote for more QE was a closer-than-expected 7 to 2, the minutes from the meeting revealed that a further cut in the policy rate (currently at 0.5%) was extensively discussed. The headline CPI rate surprised to the downside, dropping an unexpectedly sharp 0.4% to 2.4%, and validating the Bank of Engalnd expectations that this rate is likely to drop below target over the medium term once the one-time effects from VAT hikes and energy prices roll off. Second-quarter GDP, to be released next week, is likely to be negative for the third quarter in a row, albeit partly because of bank holiday effects. GBP largely ignored domestic data, and traded modestly higher against both the euro and the dollar for the second week in a row.

EUR

The week was light in macroeconomic news out of the eurozone. However, dramatic news out of Spain more than made up for this, and ensured yet another week of downward pressure on the common currency. New and ever harsher austerity packages are followed by further downward revisions of Spanish growth expectations in an accelerating vicious cycle. The latest round of measures, extracted from the Spanish Government by German austerians as a condition for the Spanish bank bailout, has once again been voted down by investors. Spanish 10 year yields broke to yet another record high, well above 7% and over 600 basis point above Germany’s. At these levels, Spain has been effectively shut off from market access. Desperate pleas for ECB intervention were flatly turned down by Draghi. Absent such intervention, Spain will need to ask for a full bailout package soon, and yet another euphemistic charade (the ‘bailout lite’ idea) will have been shattered by reality. At the risk of repeating ourselves, we continue to stand in awe of European denialism and penchant for magical thinking in the midst of the crisis. We are, if anything, more bearish still on the euro over the medium term, although we expect some sort of the short-term bottom driven by the overwhelming trader positioning and negative sentiment against the euro.

USD

Worrisome news about US consumer demand hit the wire last Monday. Retail sales surprised sharply to the downside, declining 0.5% against expectations of a healthy rise of about 0.4%. We wouldn’t normally make too much of such a volatile number. However, it is the third month in a row retail sales have contracted. This is a rare occurrence, and nearly always takes place during or right before recessions. We are not predicting a double dip recession at this stage, but it is clear that we have underestimated the impact of the European crisis in business confidence, investment, hiring, and, consequently, consumer demand worldwide; and the US is no exception.

The dollar, however, was not seriously hurt by the news, as investors seeking a safe haven continue to provide support for the greenback; it managed to eke out a small gain in trade weighted terms. We now expect the Fed to react to ongoing economic weakness and announce further unconventional measures at the September meeting of the FOMC.

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Written by Tom Tong

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