Searching for Dollars in a Basket of Eggs

BBH CurrencyView

• Dollar ended the week softer with AUD, JPY and SEK the strongest weekly performers in the G10
• Fed introduces new level of transparency next Wednesday with regular press briefings
• Euro likely to test December 2009 high, around $1.47, on the back of higher CPI

After a brief rally in the beginning of the week, the US dollar limped into the holiday weekend down versus all the majors with the Australian dollar the top performer, up 1.6%.  The euro continued to strengthen, pushing through $1.46 and reaching a new 16-month high, despite the ongoing tensions in Greece’s bond market, while sterling followed the euro higher on the week driven in part by strong data and general dollar weakness.  The yen, meanwhile, softened against most of the crosses as higher yielding “growth” currencies continued to surge.  Against this backdrop, global equities remained firm, with Asian stocks reaching a 7-week high driven by strong corporate earnings.  US and European stocks were firm as well, with the S&P and Euro Stoxx 600 up over 1.2% on the week.  As a result, renewed optimism tempered demand for safe-havens, in turn nudging bond yields higher.  On the other hand, renewed concerns over the potential for Greek restructuring led periphery yields higher, with the Greek 10-year up 94bps on the week, although Spain’s yield increased by a mere 5bps.

With liquidity and volume light ahead of the holiday weekend and therefore very little news and price action we thought we would remind investors about our views of the drivers and the outlook for next week. Most important, next Wednesday will mark a new era in Fed communication policy, with more direct contact and transparency, as the Fed introduces regular press briefings subsequent the FOMC meeting.  In terms of the policy, we expect the FOMC to reaffirm its commitment to finishing QE2 in its entirety, while at the same time providing the market some guidance about its intentions once the program is complete.  In our view, we expect the composition of the Fed’s balance to largely remain unchanged.  That means, the stock of assets on the Fed’s balance, totaling roughly $2,600 bln, will likely be reinvested into treasuries for some time and therefore the structure of the balance sheet is likely to remain intact.  But, nonetheless, this level of direct communication between the Fed and the markets should provide for some interest market reactions so buckle your seat belts.  Other important data reports in the US include GDP and PMI, both of which are expected to moderate from the prior reporting period.  Taken together, the distributions of forecasters suggest a higher probability of a downside surprise, which would like weigh on the dollar.

In Europe, the focus remains on the split between the economic strength of the core and the weakness in the periphery and the policy implications going forward.  At the same time, concerns about the potential for a Greek debt restructuring re-emerged this week, weighing on periphery debt market and marginally knocking the euro off course.  Despite these concerns and move higher in peripheral yields, the euro broke $1.46 after succumbing to some profit taking ahead of the holiday weekend.  Next week, the market will certainly remain focused on developments in the periphery with a keen eye on Spain, as a check to monitor Spain’s ability to decouple from the troubles of the likes of Greece and to less degree (for now) Ireland.  However, barring any major announcements in the case of Greek restructuring (which we view as a tail risk at this point), we expect the euro to continue its uptrend again next week.  The driver, again, is likely to be another month of increasing CPI, which in our view is likely to exceed the market’s expectations.  As such, look for the euro to retest the December 2009 high near the upper end of $1.47.

In the UK, the upcoming GDP print has lost some its luster as the MPC minutes yesterday have all but squashed the potential of a May rate hike.  On the other hand, strong retail sales coupled with an upside surprise in GDP (> 0.5%) is likely to prompt hope of a hike in late Q3.  The distribution of forecasters is "tilted" towards an “upsize” surprise with the impact on sterling likely to be binary.  That means a positive reading is likely to stoke a strong rally, while a weak print is likely to lead to a marked selloff.  In any event, sterling has been supported by the performance of the euro and the return of risk appetite.  As such, a continuation of the current market trends would likely lead cable to test December 2009 high as well, near $1.67.

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