EUR/CHF hits 1.35 target

Tue, Jun 29 2010, 06:16 GMT
by Kenneth Broux

Market Outlook

Tactical view:

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

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 twoweek 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.

G10 FX - EUR/GBP, further downside targeted

The descent of EUR/GBP since March continued virtually uninterrupted this week as the pair progresses below 0.83 to a 0.8181 low and the reciprocal GBP/EUR rate motors through 1.22 to a 1.2223 high. A bullish technical set-up (see chart p2) is accompanied by the still volatile backdrop in EU peripheral bonds based on deeper rooted funding and liquidity concerns, and argues for EUR/GBP to extend to 0.80 in the short-term (1.25 for GBP/EUR). Our bullish stance is partially based on the view that EUR/USD underperformance vs GBP/USD is set to continue. Though we are uncomfortable with the rally in GBP/USD up to 1.5012 because of the broader context of risk aversion, the dual fillip from the emergency Budget and a more hawkish MPC tone could tempt participants to cut back on the share of short GBP/ USD positions vis-a-vis EUR/USD.

A stalling of risk appetite in June and the 40% collapse in the Baltic Dry since May have not stopped EUR/GBP from breaking back below 0.83, with a public endorsement by the ratings agencies of the June 22 Budget bolstering GBP sentiment. Though the correlation of GBP/USD with equities and commodities has eased from earlier May peaks, GBP/USD is still better placed to benefit from any relief bounce in risk compared to EUR/USD, though the prospect for a summer rally in stocks looks increasingly bleak as doubts over the economic recovery return and make way for speculation of renewed asset purchases by the Fed. Controversially, it is not unthinkable that the prospect of new central bank measures to bolster liquidity could support risk as observed between Mar-09 and Jan-10, albeit on a smaller scale.

Separately, perceptions of a structural shift in EUR sentiment may result in a reduction of EUR portfolio holdings by a number of market participants including real money funds and reserve managers. The account of EUR in global currency reserves has shot up from 17% to 27% over the last 10 years. We await the IMF Cofer statistics for Q1 due on June 30 to understand if any changes in the composition of global fx reserves is taking place. Because of the EU debt crisis and niggling uncertainty over capital adequacy and counterparty risk, we think exposure to EUR assets is likely to be scaled back, reversing the bullish trend of the past decade.

Additionally, GBP may derive support from a shift in the MPC’s policy bias if confidence grows that the recovery is developing stronger momentum in the second half of 2010. A first vote for a rate hike in June hike since July 2008 (by MPC member Sentance), though not representative of the overall neutral bias of the rest of the committee, means a more fragmented view could buoy GBP demand should the BoE decide to re-calibrate its inflation outlook in the August QIR.

Finally, the combined impact of tighter fiscal policy, rising real interest rates and a stronger exchange rate is undesirable and may not enhance the prospects of a more balanced economic recovery. The BoE has not held back in the past from defending the virtues of a weaker exchange rate in the context of the need for economic rebalancing and though currencies fall outside the BoE policy remit, it is not unthinkable that the MPC could again turn more vocal should participants bid up GBP.

EUR/GBP: 0.8165 before 0.80. Setting up for a pullback to 0.78?