With risk easing, dollar still suffers

The stage is set for EURUSD to make another stab towards 1.5000. A weekly close above 1.4500 is extremely constructive for the pair and we may see 1.4670 first and then the 1.4850 highs from early May.

But there is one large caveat to this. To start with Portugal holds a snap election on Sunday. Any sign that political turmoil will threaten its deficit reduction program may weigh on sentiment towards the single currency. Banking sector stress tests are also due for release this month (though there have been reports that the Eurozone bank regulator has requested banks to re-submit fresh data, suggesting a possible delay) and Spain has set a deadline of September for its troubled Caja banks to re-capitalize. So there are potential obstacles the euro has to climb to remain well supported. But as long as the prospect of QE3 in the US remains on the table then this should favor the euro over the greenback in our opinion.

Is the BOE getting more dovish?

Last week could end up being one of the most pivotal of the year for the Bank of England. Andrew Sentance, who had voted for 12 straight rate increases (and been voted down on each occasion) left the Committee as his term on the MPC expired.

In a television interview on the day he stepped down Sentance said the Bank risked its credibility by not raising interest rates and allowing inflation to reach 4.5 per cent. However, just as his words hit the airwaves there was further evidence that the economy is slowing and weak GDP in the first quarter is seeping into Q2.

Firstly there was the PMI manufacturing survey, which tumbled to its lowest level since September 2009. Additionally, the services sector survey, which represents the lion’s share of the UK economy, also fell in May to its lowest level since February. Cracks are starting to emerge in the UK ’s growth picture and this makes a near-term rate hike extremely unlikely.

This was reinforced when one of the more dovish members of the BOE Paul Fisher said that he was open to the idea of extending the Bank’s asset purchase program if the economy was to contract sharply. He also reiterated his stance on rates, saying that it was too early to hike.

Of course Fisher is only one member of the Committee, but Sentance’s replacement Ben Broadbent, a former Goldman Sachs economist, seems to have a less hawkish bias than his predecessor.

Interest rate expectations for the rest of the year have fallen sharply since February and they remain back at October 2010 levels, when a rate hike was barely priced in for this year. We think that the outlook is too cloudy to pinpoint exactly when the Bank will normalize interest rates, but currently it looks like it may not be until the first quarter of 2012.

Low rates and weak economic data are weighing on the pound. While we think it will eventually grind lower against the dollar, we think it will experience a sharper move against the euro and the Swissie. Although the franc is at record highs versus the pound, we think it may move lower towards 1.3500. We also think that the pound looks more vulnerable than the euro right now, and this supports a move towards 0.9000, the highs last reached at the start of May.

Steady RBA cash rate…for now

Australia’s economy contracted -1.2% in the first quarter as the aftermath of Queensland flooding negatively impacted commodity export volumes. The drawdown in GDP alongside disappointing April employment numbers in the midst of a moderating global recovery will likely see the RBA hold its cash rate steady at 4.75% for the seventh consecutive month on Tuesday.

However, we expect the policy statement to contain hawkish undertones similar to those in the May 3rd minutes – ‘If economic conditions continued to evolve as expected, higher interest rates were likely required at some point if inflation was to remain consistent with the medium term target’ – as Q2 GDP looks set to rebound from firming domestic demand, business investment, and public consumption.

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