Persistent rumours over an agreement to help stop the sovereign debt crisis spread throughout the Eurozone helped to drive the FX and financial markets. These developments, along with positive economic data from the US and core Europe helped propel the EUR, GBP, commodities and stocks to high levels. There was also a selloff on the dollar and a serious back up in European core yields.
Sterling had a mixed performance for the week, driven entirely by the rumours and leaks over European action on peripherals. Domestically, there was a relative lack of news that would help clarify the critical issue in this coming year: whether the British economy can withstand the significant fiscal tightening that has already started. The Bank of England met, and no changes were made to either the level of rates or the size of the balance sheet; as is customary when no change is made to monetary policy, no statement was released, so we will have to wait for the minutes of this meeting to see whether any significant change has taken place in the outlook of any of the members. Driven mostly by the sharp rally in the euro, sterling rose more than 2% against the greenback but dropped about 1.5% against the common currency, without a doubt the star of the FX week.
It was a critical week for the common currency, both in terms of market moves and underlying news. Although so far all remains uncertain, based on rumours, leaks and statements by individual officials, it appears clear that major changes are afoot in the way the peripheral crisis is going to be dealt with. We are pleased to say that these changes appear to bring Eurozone officials much closer to our way of things. If the above mention newsflow is to be believed, all the following are being considered: an increase in the size of the funds available for bailout in order to make it large enough to remove any uncertainty as to whether Spain can be bailed out; a change in the bailout conditions, including (in an unsourced report in the Irish press) a lower interest rate that would enable the stricken countries to achieve solvency, and giving the bailout facility the ability to intervene directly in the markets. This news, helped along by panicky short covering, led to a sharp rally of over 3.5% in the EUR/USD rate.
We stress that all of the above is based mostly on rumour, leaks and speculation. However, should these measures be implemented, they would constitute in our view a critical change for the better in the Eurozone crisis. Also, both the price action last week and the CFTC traders report indicate that speculators have turned around their positions in the last few weeks and are actually short on the euro now. Therefore, we change our bearish view on the euro to a neutral one, as we await confirmation of which (if any) of the above measures will be officially implemented.
The greenback had one of those rare weeks in which it is driven by news flow from the rest of the world, rather than the other way around. Weak retail sales did not quite dispel the sense that news flow from the US economy has turned rather positive, and GDP growth forecast for the current quarter were generally raised by forecasters to 4% or even a bit above. US rates moved relatively little, compared to European rates. Therefore the USD essentially took its cue from the sharp rally in the EUR, though it held better against most other major currencies and ended the week down 1.2% in trade-weighted terms.
The new year has not altered the strong correlation between US rates and the Japanese Yen. The absence of market moving news from Japan actually strengthened this tendency. In spite of the turbulence in Europe, US rates ended the week nearly unchanged, as did the Japanese yen.
Dollar bloc currencies rallied in a positive week for commodities, with the conspicuous exception of the Australian dollar. The seriousness of the flooding in Queensland jumped to the forefront and at some point last week’s futures markets were actually pricing in some chance of an RBA cut in rates. While we do not have an official reaction from monetary authorities yet to the flooding, the AUD lagged notably, dropping over 0.5% vs. the USD in a week where CAD rallied about that amount and NZD outperformed all dollar bloc currencies rising over 1%.
Norwegian inflation surprised significantly to the upside, though core inflation was only slightly higher than expected. Markets quickly upgraded their expectations of Norwegian rate hikes. Not surprisingly, NOK sharply outperformed its Swedish counterpart, given the tamer inflation numbers out of Sweden. While SEK was slightly down vs. the euro, NOK rose over 1.5%.
Last week brought relief to the Swiss National Bank in the form of a massive sell off of the Swiss franc vs, the euro. As risky assets rallied and the rate differential to Europe rose, the Swiss currency lost a large 3.4% against the euro. This brought a sharp reminder to traders that the CHF is not necessarily a one-way bet, and given the heavy positioning in this cross and the lofty levels at which the CHF still trades, we would be not be surprised to see it sell off further in the coming weeks.