Dollar swoons; more weakness is likely

Tough decisions for the ECB

The Eurozone inflation report released on Friday would have made for some uncomfortable reading at the European Central Bank. Prices are rising in the currency bloc at a 2.8 per cent annual rate in April, up from 2.6 per cent in March. For a central bank that has a sole mandate of price stability then surely rates should rise to stub out inflationary pressure?

However, rising commodity prices are weighing on the inflation rate and this is starting to erode economic confidence. Consumer, economic, industrial and service sector confidence all moderated last month. Although confidence levels are coming off their highs it points to a slowdown in the recovery in the Eurozone, which may make some members of the ECB slightly wary about raising rates at too quick a pace.

On Thursday’s ECB meeting we will see what wins out between the inflation/ growth fight. Right now the market is looking for another rate hike late in the summer and Euribor rates and Eonia- euro swap rates remain at elevated levels.

If the ECB remains as committed to price stability as it says it is then we could hear ECB President Trichet use the code words “strong vigilance” to signal a rate hike slightly earlier at the next meeting in June.

This would sit alongside the fairly hawkish rhetoric coming from ECB members in recent weeks. Last week Luxembourg central bank chief Mersch said that policy has to be decided for the region as a whole rather than for individual countries. This suggests that the ECB may not consider the concerns that Greece may have to default on some of its giant debt load in the near-future.

Peripheral bond markets have come under heavy selling pressure this week with Portuguese and Greek bond yields reaching euro-era highs. Greek 2-year bond yields are now above 26 per cent and Italy and Spain have also had to pay a higher risk premium to investors at recent debt auctions.

A combination of high interest rates and an elevated euro are all likely to weigh on growth in the peripheral economies. EURUSD surged 2.5 per cent last week alone as the Federal Reserve sounded fairly committed to low interest rates at its meeting last week. 1.5000 is now in easy reach and possibly even 1.6000 next.

At these levels the euro could start to hurt exports at exactly the wrong time. The Spanish deputy finance minister spoke on Friday after the Spanish unemployment rate reached a 14-year high of 21.29 per cent in March and retail sales slumped by 7.9 per cent, saying that exports will be the key to the Spanish economic recovery. But this won’t be possible if European goods become less competitive on the global market.

While the EURUSD has surged 10 per cent since the start of this year, the single currency is up 9.5 per cent versus the Chinese renminbi, a major market for European exporters. Thus, the ECB also needs to weigh up the impact of an imminent rate hike on the already elevated exchange rate. So watch out on Thursday, firstly for the phrase “strong vigilance” and secondly, if Trichet makes any reference to the strength of the single currency.

UK recovery looks half-hearted

If members of the MPC were waiting for an update of the first quarter growth figures before making up their minds about hiking interest rates then the 0.5 per cent expansion was fairly lackluster. At the start of the year a rate hike at this week’s meeting was nearly fully priced in, but that has been reversed. Signs of a flagging recovery, a negative growth reading at the end of 2010, and signs that BOE Gov. King remains intent on holding rates steady in the months ahead, have all dampened interest rate expectations.

Market watchers will now wait for economic signals about how growth progressed in the second quarter but the prolonged Easter/ Royal Wedding holiday is likely to ensure that growth remains erratic in the UK for some time to come. Interest rate expectations were pushed back further last week and the markets now expect a rate hike (based on Sonia inter-bank lending rates) in the last quarter of 2011.

This is weighing on the pound against the stronger currencies like the Aussie and the euro but GBPUSD remains very well supported, it is currently at its highest level since December 2009. We prefer short sterling positions against the Aussie and the euro in particular, as we believe that the dollar will remain under pressure for some time yet as the Fed remains committed to an ultra-loose monetary policy.

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