FX Strategy Weekly by Lloyds TSB

The rotation out of risk (equities, credit, commodities) continues to dictate safe-haven flows into the JPY, and to a lesser extent into the USD. Tactical view:

‘Risk off’ mode: JPY to extend gains?

The rotation out of risk (equities, credit, commodities) continues to dictate safe-haven flows into the JPY, and to a lesser extent into the USD. The currency market remains very much agnostic to the macro data flow from the G10, instead putting greater emphasis on the direction of equities, credit and commodities. We look for the sensitivity to risk assets to remain elevated over the week ahead and markets to only pay minor interest to revised UK and US Q1 GDP data. A break of key technical levels in commodities and equities does not augur well for AUD, GBP, EUR and has raised the threat of a decline in GBP/USD to 1.40, with the JPY ideally placed to attract the rush out of commodity and higher yielding currencies if risk aversion does persist.

• Recap

Germany’s unilateral decision to ban naked short selling of government bonds, CDS and shares of its top 10 financial institutions sent shockwaves through global financial markets, prompting participants to shun risk assets and currencies in favour of the USD, JPY and government bonds. The AUD dropped like a stone vs all G10 currencies, shedding a staggering 13% vs the JPY and 9% vs the USD. GBP/AUD rallied over 6%, taking out key resistance in the 1.70 area. The moves are collateral damage from the risk aversion trades that are stalking the EUR, though some credit for the flight out of the AUD is owed to geopolitical jitters on the Korean peninsula and the (exaggerated) reaction in commodities. The CRB index flirts with key support around 250, squeezing the commodity heavy FTSE-100 closer to 5,000 (-7%). GBP experienced a fairly mixed week, losing 3% vs the JPY, but gained ground vs the high yield and commodity currencies.

• UK CPI topped forecast estimates for a third month in four, climbing to 3.7% y/y in April vs 3.4% in March. RPI surged to 5.3% y/y vs 4.7%, and core CPI topped 3%. This is in contrast to the US where core CPI fell last month to 0.9% y/y, the lowest since 1966. The MPC minutes reaffirmed that inflation is projected to fall back to target, but the Bank has come under growing pressure for consistently underestimating and missing previous inflation forecasts. Retail sales rose a stronger than forecast 0.3% m/m in April.

• UK 5y swaps extended their slide below 2.50%, hitting a low of 2.43%. This caused the 3mth libor/5y swap curve to flatten to 180bp, the lowest level since May-09. The 2y/10y swaps curve flattened to 203bp. Gilts were bid for most of the week on flight-to-quality flows, with 10y yields dropping below 3.60% to a 3.54% low. The 10y gilt/bund spread widened a fraction to 90bp. The corporate market remains devoid of new sterling issuance in May.

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