FX Strategy Weekly By Lloyds TSB

EUR/CHF hits 1.35 target; JPY back in demand; USD safe haven status faltering?
Market Outlook

Tactical view:

= EUR/CHF hits 1.35 target; JPY back in demand; USD safe haven status faltering?

The resilience of GBP and stale USD performance vs G10 currencies in a broader context of risk aversion is a new development and will bear close watching over the week ahead as we square up to heightened event risk from the US and the euro zone. Investor scepticism has been underlined by the 40% collapse in the Baltic Dry and a dreadful sequence of US housing data for May, drawing support for the JPY and CHF. A second disappointing US employment report in as many months threatens to further derail confidence and could add to the view that the Fed will eventually have to resume asset purchases. The ECB one-year tender expires on Thursday. The quarterly IMF Cofer statistics covering changes in Q1 FX reserve composition are due on Wednesday.

• Recap

• A solid weekly performance saw GBP rally against all G10 currencies bar the JPY as the correlation with risk turned lower. Bolstered by hawkish MPC minutes and the endorsement of the UK Budget by the credit ratings agencies lifted GBP/NOK to the top of the rankings with a 2.7% gain, followed by GBP/CAD (2.6%) and GBP/EUR (1.6%). China’s decision to de-peg the yuan from the USD resulted in USD/CNY hitting an all-time low at 6.7860, but the impact on the broader G10 was muted with JPY gains primarily attributed to the flight from risk. The CHF continues to attract solid demand since the June 17 SNB meeting, and progressed to below 1.35 vs the EUR. USD/CHF slipped below 1.10.

• News that MPC member Sentance voted for a rate hike at the June meeting came as a shock and was the highlight of a week primarily dominated by the emergency Budget. Though the majority MPC view still points to low interest rates for longer, Mr Sentance’s dissent indicates that the policy debate could be become more fragmented if the recovery is sustained in the second half of the year. The regime of fiscal austerity imposed by the Chancellor leaves many question marks over the direction of the economy. The Budget foresees GDP growth of 1.2% this year and 2.3% in 2011, with CPI inflation on target. An additional £40bln of fiscal tightening means net borrowing is projected to fall from £155bln of GDP this year to £37bln by 2015.

• A stellar performance for UK rates saw 5y swaps return to the lower end of the trading range and 10y yields slide to the lowest level since last October, cracking technical support at 3.44% and 3.40%. Key support runs at 3.35%. 3-mth Libor was unchanged at 0.73% for a 3rd week running, causing the 3mth Libor/5y swaps curve to flatten to 176bp, a two-week low. The 3mth Libor/Ois spread ended the week marginally tighter at 23.5bp. The 2y/10y swaps curve flattened 6bp to 197bp. Failure to break 206bp leaves the curve vulnerable to a corrective flattening to 192bp. Following this week’s lull, gilt sales will resume next week with the auction of £800mln, 0.75%, 2047 IL paper.