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Friday November 12, 2010 - 18:42:32 GMT
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FX Strategy Weekly - Market Strategy

FX Strategy Weekly - Market Strategy  Friday, 12 November 2010



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.



Quantitative Market Analysis

USD short positions reduced

AUD wobbles on risk aversion


Contrarian Indicators

Risk Reversal Skews (based on options prices, see page 7) and IMM data (highlighting speculative positioning, see page 6) are used to analyse foreign exchange to understand how stretched currencies may have become. Long GBP speculative positions rose for the first time in three weeks, raising the total number of longs to 15,1000, the highest since Mar-08. A rare bullish response to the BoE QIR midweek (despite unchanged 2y inflation target) will have attracted additional buying interest and so a further increase of GBP longs will probably have taken place over the past week. However, profit taking in GBP/ USD spot may have occurred on renewed jitters in the EU periphery and doubts over the funding position of Ireland. GBP/USD ended the week 0.2% higher above 1.6150 thanks to a remarkable bounce on Friday from a 1.5986 low.


Doubts over the EU periphery obviously also forced EUR bulls on the backfoot and will in all likelihood have chopped the number of EUR longs vs the USD lower for a 3rd successive week to a 4-week low. A statement by the ‘big five’ on Friday with regard to sovereign bond holdings rescued EUR/USD from further immediate losses, but may temper enthusiasm to back EUR/G10 crosses back up even as EU bond and credit spreads tighten. EUR long positions now stand at 38,600.


CHF and JPY positioning stayed virtually flat at -12,400 and -46,000 respectively, but this will in all likelihood be a misrepresentation of investor sentiment. The sell-off in EUR credit means that long CHF and JPY positions will have been sought as a refuge replacing pro-risk strategies so long positions vs the USD should have modestly increased over the last 48 hours. The same logic applies to AUD and CAD but here the inverse probably occurred with long positions trimmed back in response to lower stocks and wider credit spreads. Long CAD positions have nearly halved to 23,000 from over 42,000 in the first half of October, with the level in USD/CAD virtually unchanged (1.01).


No change in trend for risk reversals as demand for USD calls is favoured , leading 3mth tenor to slide to -1.90, levels last seen mid-September (spot 1.2679). Risk reversals also move slightly tipped in favour of USD calls vs GBP (- 1.27) but overall bear no comparison to the meaningful shift vis-a-vis EUR over the past couple of weeks. Though 3mth USD/JPY RR edged up from the 10.815 low to 11.26 and spot rallied back over 82.0, there is no indication that a bounce in USD/JPY is becoming established.


Last week we commented on the increase in correlations of the AUD/USD with S&P, oil and CRB and how this exposed the AUD to profit taking if risk appetite turned over. We got just that this week as EU credit spreads zoomed and equities fell. As a result the AUD paid a heavy toll and remains exposed to future turbulence, even though underlying fundamentals are still supportive. The same applies to USD/CAD, albeit to a smaller degree. For GBP/ USD, the correlation with the S&P, gold and oil is also in the ascendancy. Though not quite reaching the levels of AUD/ USD, there are obvious dangers for a pullback in GBP/ USD if the negative tide vis-a-vis risk were to intensify. This is in contrast to EUR/USD where traction with risk assets is statistically insignificant, though we caution for an overreaction to the downside in the event of a renewed surge in periphery credit spreads.


The balance of economic surprises in the US continues in the same vein with positive surprises outnumbering negative surprises and this backing a bounce in US short-term yields. The stakes are raised next week when retail sales, CPI, industrial output and Philly Fed are published. The prospect for higher short-term US rates needs close monitoring as 2y yields approach 0.50%, a key psychological level. A tightening monetary policy in China and rising short-term rates in the G10 could in itself inhibit greater demand for risk appetite, causing previously cyclical outperformers like AUD, NZD, SEK and NOK to move into the slow lane.



Lloyds TSB Corporate Markets Economic Research, 10 Gresham Street, London, EC2V 7AE, Switchboard: 0207 626 1500





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