Euro resumes downward trend as FX correlations weaken

Tom Tong13/Aug/2012Currency Updates

Currencies continued to move somewhat erratically last week, bucking the overall tendency in financial markets towards risk-on / risk off moves. The Euro resumed its downward trend. Short positioning against the common currency has come down fairly dramatically from its record highs of a few weeks ago, and absent support from short covering the Euro moves mostly downwards. This shift in tendency is meaningful, as equities rose sharply throughout the week, an environment that used to be very supportive for the Euro. We expect the relative stability in currency markets to continue until September, when the Spanish bailout and the poor data out of the UK and Europe will take centre stage again.

GBP

The main news for sterling last week came from the Bank of England, as the quarterly inflation report was published. It struck a distinctly gloomy note, revising downward the Bank’s central expectation for both GDP and inflation. In the press conference following the meeting, Mr.King suggested that a cut in rates from the already minimal 0.5% is not in prospect, as it would be potentially counter-productive, and that at this point quantitative easing remains the most effective channel for monetary policy in the UK. We are now pencilling in a further increase of GBP 50 billion in the gilt purchase target in November. The macroeconomic picture is not improving, and a large drop in June exports provided further evidence that the European train wreck is increasingly affecting British prospects.

EUR

Last week brought no dramatic news from the eurozone, as Governments and ECB officials enjoy the August vacation. Macroeconomic news were, once again, somewhere between disappointing and disastrous. The Italian economy contracted by 2.9% QoQ saar – the third quarter in a row of contraction at very similar levels. Both Italian and Spanish industrial production continue to contract YoY at a pace in the high single digits, so there will be no change in economic momentum any time soon in the two biggest peripheral economies. Unsurprisingly, the collapse in these key export markets for German products continues to impact industrial production, factory orders and exports; all of these reported significant contraction in June. With the short position against the common currency mostly cleared out, the Euro resumed its downward trend last week. While we do not expect dramatic news until September, we are comfortable that the bearish trend in the Euro will bring it down near the key 1.20 level in the near future.

USD

Last week was one of the lightest in the year in terms of relevant macroeconomic or policy news. What news there was was mostly positive: weekly jobless claims dropped to 361,000, suggesting that layoffs in the US have resumed their gentle downward trend. Exports surprised to the upside, and have now risen at a double digit annual rate over the past three months. However, increasing attention is being paid to the “fiscal cliff”, i.e., the massive fiscal drag that will take place at the end of the year unless Congress and the President agree to extend some portion of the Bush tax cuts and prevent automatic spending cuts. We are very sceptical that any such debacle will actually take place, given the near-consensus among top financiers and executives about the very negative effect this would have on US prospects. Therefore, we would lean against any sharp market moves brought about by these exaggerated fears, although we note that no such movements have materialized so far.

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Written by Tom Tong

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