FX Strategy Weekly by Lloyds TSB

=> USD priced for QE2 after Bernanke, pro-risk flows weigh

=> GBP: MPC minutes ahead, bias still neutral? Market Outlook

Fed chairman Bernanke implicitly admitted in his Boston speech that the Fed was likely to push ahead with more QE on Nov 3 as risks of deflation are currently “higher than desirable”. The limited scope for US short end yields to fall suggests that USD downside may now be limited. However, with QE2 now effectively priced in, the risk of a counter trend move cannot be ruled out, though a leveraging up of G10 and EM currencies threaten to squeeze the USD lower still backed by positive US Q3 company earnings and a rally in commodities. In general, a combination of reasonable US activity data and a Fed commitment to more accommodation should be positive for risk appetite, and suggests that carry trades should still be favoured, though it is becoming less clear that the USD is still offering best risk/reward as a funding currency.

For the week ahead, the focus turns to the UK. The MPC minutes on Wednesday could show that Posen voted for more QE, while Sentance carried on voting for a rate hike. In practice, it may well be that Posen will wait until November before voting outright for QE, but we should find out whether the balance may be tilting early. With US 2 year swap rates now down to 50bps, UK 2 year rates at 1.23% may start to look anomalous if the Bank indicates a potential for further QE as early as November. Economic data have certainly provided ammunition, with clear evidence of weaker growth in H2 from a variety of leading indicators and the looming Comprehensive Spending Review pointing to weaker growth ahead. All this suggests that GBP/USD may struggle to hold on above 1.60, though additional flows into commodities and the FTSE could tempt buyers on dips.

EUR/GBP should also have more near-term upside, as recent comments from ECB’s Weber and Stark leave the impression that the ECB is starting to move to a more hawkish bias. While both are well known hawks, they are also senior and influential on the governing council, and last week’s comments were as strident as they have been for a long time. In addition, while funding strains remain in the European periphery, spreads over Germany have narrowed and sovereign CDS have also edged down, confirming that concerns may slowly be fading as supply remits for the year are completed. This may allow risk premium in the EUR to moderate.

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