Since Thursday of last week we have seen nearly 1% knocked off Spanish government bond yields, largely as a result of the comments from the ECB President hinting strongly at more action from the central bank and others to help push borrowing costs lower.
How the single currency should approach Thursday’s ECB meeting is more complicated. There’s been a fairly strong inverse relationship between the EUR and yields on peripheral debt and this has been getting stronger of late with the inverse relationship at its strongest level for the year to date at -0.72 (on a 1mth rolling basis). This makes the euro particularly sensitive to any disappointment later this week should the ECB not follow through with more concrete measures to keep borrowing costs of troubled nations down. Before then we have both the US Federal Reserve (tomorrow) and Bank of England decisions (Thursday), but the risks for currency markets from these events are small in comparison to the ECB result.
The flaming Aussie. Once again the Aussie looks to be on fire, having broken through the 1.05 level in overnight trading. So far today is proving to be its fifth consecutive up day vs. the USD and it has now unwound all of the depreciation seen during May. A remarkable performance, especially when compared with the soggy price action seen in many commodities over the past two months and also other risk barometers against which it has normally showed a strong correlation, such as emerging Asia equities. We wrote more in depth about this in our blog of yesterday (‘The shifting sands of FX’), but in the short-term the better tone was helped by overnight data showing better than expected building approvals data, further reducing the risk of a surprise rate cut at the RBA meeting early next week.
The push and pull on EUR/GBP. For most of July sterling seemed pretty unstoppable vs. the single currency, but after EUR/GBP hit a near 4yr low early last week, the strains have been starting to show. The main catalyst was the surprise fall in GDP data seen in Q2 (down 0.7%), but it’s not all bad news for the pound. Since then, EUR/GBP has been pushing tentatively lower and did its best to make up further ground on Monday, but the cross found buyers below the 0.78 level. Even though there is some talk of the euro turning more into a funding currency in the wake of the ECB’s cut in rates earlier in the month, there is little evidence of this at least on this cross. The correlation between EUR/GBP and the spread between 2yr interest rates in the UK and eurozone (using swap rates) has been declining, with the move seen this month happening at a time when interest rates spreads were pretty steady.
That said, the shifting expectations surrounding the direction of both central banks could well play a role on the cross this week. Expectations ahead of Thursday’s ECB meeting are building, not of rates, but of the possibility that it is set to sanction a more aggressive approach to buying the bonds of peripheral eurozone nations. Meanwhile, having only just sanctioned further bond purchases, there are few expectations that the Bank of England is going to follow through this early on with a cut in the official bank rate from the current 0.50%. How any potential ECB action will impact on sterling is a harder call. For most of the past two years, the single currency has displayed a negative correlation with peripheral yields, weakening as yields in the likes of Italy and Spain move higher. So, if the ECB does follow through with actions after last week’s words, EUR/GBP could well struggle to push new lows for the year.