London Session

Sterling, the AUD and the NZD have all made huge gain vs the USD this morning; the EUR has also seen a sizeable rally. The weakness of the USD can be linked to the US treasury market and fears over the ballooning size of the US budget deficit.

The rise in long term US interest rates and weaker USD are consistent with the view that the market has reduced its ‘safe-haven’ long positions which were built during the height of the financial crisis. Even though it is possible that there could be further bad news ahead, demand for safe haven assets is presently out of favour. For now focus is on how the US will reduce its deficit and fund its debt going forward, and crucially who will buy the debt. Treasury Secretary is visiting China. He reassured his hosts overnight that he wants to shrink the budget deficit to around 3% of GDP. These reassurances are necessary given the huge proportion of US debt that is owned by the Chinese and other overseas investors. However, it will be a huge effort for the US government to reduce its budget deficit. In the meantime it seem reasonable that overseas investors will demand higher yields to compensate them for holding Treasuries given the increased risk associated with higher supply and given the longer-term inflationary threat implied by QE. The Fed, however, are trying to keep long-term interest rates down through QE to re-inflate the economy. There is a risk therefore that QE could put overseas buyers off. However, if the Fed does not announce more QE there may be risk that the economic recovery could falter. US policy makers will have to tread carefully in the months ahead with respect to the amounts of QE. In the meantime, the market is playing safe by selling the dollar.

The weakness of the USD is feeding the rally in commodities and giving significant support to gold. The AUD and the NZD have surged, and further upside to ‘risky’ currencies is likely if the Fed does increase its QE plan. Sterling is also benefitting from the rally in risk, with cable bursting through the USD1.6250 area in early London trading before meeting some resistance ahead of USD1.6400. News overnight from the UK Hometrack survey showing house stable prices in May also helped sterling as did the better than expected manufacturing PMI data which rose to 45.4 in May from an upwardly revised 43.1 in April. EUR/GBP has pushed down towards the EUR/GBP0. 8670 level before running into support. PMI data from Italy and Spain and final PMIs from Germany and France all showed improvement lending support to the EUR’s rally vs the USD. EUR/USD surged higher in early European hours but ran into sellers at EUR/USD1.4240

This afternoon, US personal spending and ISM data is due. Canadian Q1 GDP will be released.