FX Strategy Weekly by Lloyds TSB

The USD continues to attract solid buying interest as confidence in the EUR and GBP wanes. With risk reversals still heavily skewed towards USD calls, the outlook for the dollar index remains uniformly bullish even as the probability of a Fed rate hike this year fades. Market Outlook

Tactical view:

EUR crosses stay offered; counting on stocks for GBP relief

USD, JPY outperform in risk averse world

The USD continues to attract solid buying interest as confidence in the EUR and GBP wanes. With risk reversals still heavily skewed towards USD calls, the outlook for the dollar index remains uniformly bullish even as the probability of a Fed rate hike this year fades. Economic data has been playing second fiddle in recent weeks and until the picture for risk assets clears up and EU debt fears subside, we think macro data are unlikely to be critical for price action near-term. The high correlation with equities continues to weigh on GBP but with the BoE now also reasserting its influence, we see no immediate escape for GBP from the clutches of the sterling bears. April retail sales and CPI data, and the MPC minutes will keep GBP on a knife-edge next week.

Recap

The positive knee-jerk reaction to a Cons/LD government quickly petered out and saw the market re-establish short GBP positions vs the principal G10 currencies except vs the EUR. GBP/USD dropped below 1.45, and following a dovish BoE QIR, the cross is now slowly gravitating towards the 1.40-1.44 area. Buying of EU peripheral debt by the ECB briefly underpinned the EUR, but selling resumed as the Ascension Day holiday pushed peripheral spreads wider again over bunds. EUR/USD slipped below 1.2500 and now threatens 1.2330, the Oct-08 low. The JPY and USD were the best performers in the G10 as a probe into US sub-prime mortgages and lower commodity prices caused equities to resume their decline, spurring a flight-to-quality. The CAD held up remarkably well considering the fall in crude oil below $75 to a 3-month low, but looks well placed to draw support from the outlook for higher interest rates.

Economic data continues to be a sideshow to the jitters in equity and sovereign debt space. The BoE kept Bank rate unchanged at 0.50% and the APF at £200bln, but in its quarterly Inflation Report it warned of downside risks to growth as public spending cuts in the EU and the UK threaten to hit demand. The BoE also sees CPI below 2% target in two years time based on the implied futures curve for interest rates. Manufacturing production rose a much stronger than forecast 2.3% m/m in March, fuelling speculation of an upward revision to Q1 GDP later this month. Jobless claims fell in March by 27,100, and the ILO unemployment rate held steady at 8%.

UK 5y swaps slumped from a 2.94% high on Monday to 2.66% on Friday, causing the 3mth libor/5y swap spread to narrow below 200bp. A similar drop in gilt yields kept swap spreads within recent ranges. EU and US yield curves also flattened, with good demand at benchmark auctions and risk aversion driving the compression in long dated yields. Libor/OIS spreads widened in the US, the UK and the EU.

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