FX Strategy Weekly by Lloyds TSB

Rumours continue to fly around about the possibility of Ireland seeking aid from Europe, and many are speculating that something will emerge from the Euro-area finance ministers meeting on Tuesday, if not over the weekend. But the situation is hard to judge.

Market Outlook

=> Irish question remains centre stage for EUR

=> UK data and minutes this week may threaten positive GBP tone

Rumours continue to fly around about the possibility of Ireland seeking aid from Europe, and many are speculating that something will emerge from the Euro-area finance ministers meeting on Tuesday, if not over the weekend. But the situation is hard to judge. While yield spreads have widened dramatically in the last couple of weeks, this is of little current concern to Ireland as they have no need to fund until the middle of 2011. So while it may well be the case that they are forced to access the EFSF (European Financial Stability Facility) when they need to issue debt next year, there is no obvious reason why they need to do so now. There are two possible triggers. One is that the Irish government sees some political advantage in doing so, perhaps from being seen to do something, but it is probably more likely that they would wish to avoid the stigma of seeking a bailout. Perhaps more likely is that the government is pressurised by other EU states that do need to borrow from the markets in the near term, Spain next week for instance, as the contagion is increasing borrowing costs for all the peripheral nations. But it is far from clear that this would be enough to convince the Irish government to seek a bailout they do not yet need. While some argue that they will inevitably need it, the fluctuations in markets in the last 6 months should be sufficient evidence that nothing is certain about the need for a bailout in mid-2011.

On balance, therefore, we doubt that Ireland will cave into market pressure. What does that mean for the EUR? On this week’s evidence, it may mean it comes under more initial pressure, but with markets already coming close to pricing in default on Irish debt, we are approaching some natural limits to EUR weakness on this score without some actual event.

Sterling has enjoyed a strong couple of weeks in the aftermath of the strong Q3 GDP figures, better than expected PMI data and a Bank of England Inflation Report that was perceived as being on the hawkish side. But this week’s MPC minutes have potential to challenge that view, which we feel was in any case more interpretation than reality. The probability is that the minutes this week will again show a 1-7-1 distribution in the vote, but there is a slight risk of a second vote for an increase in the asset purchase program. Sterling risks consequently slightly to the downside.

USD strength last week has potential to extend as US yields have risen sharply and suggest scope for gains in the more rate sensitive pairs, notably USD/JPY. But Fed QE asset buying every day next week may well limit the upside in rates and the USD, though as long as uncertainty remains in the Euro-zone, EUR/USD is likely to continue to favour the downside.

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