Risk aversion and safe haven flows dominated currency markets as sentiment continued to deteriorate amongst investors that are concerned about the high levels of sovereign debt and continued risk of contagion within Europe.

Weakness for sterling came early on as PM David Cameron and Chancellor George Osborne both triggered UK debt concerns amongst market participants. Cameron stated that the new government had found ‘very bad’ spending decisions by the previous administration while the Chancellor commented that the Labour government had “fiddled” forecasts to support their spending proposals. Osborne also accused the previous government of pursuing a “scorched earth policy” ahead of the elections and leaving behind billions of pounds in hidden spending commitments.

The main events for the pound was the release of CPI inflation figures and the Bank of England’s MPC minutes. CPI data came out at 3.7% y/y in April, this was higher than the previous 3.4% but had little impact as interest rate prospects were unlikely to change as a result of the data. With CPI being above 3%, the threshold on inflation that requires an explanation from the central bank, Governor Mervyn King’s comments pulled the pound down further.  King stated that the surge in inflation was temporary and masked the “substantial” spare capacity created due to the unprecedented fiscal stimulus measures taken, but that policy makers were “very conscious” of price risks. He further suggested that the MPC would reduce or extend monetary stimulus as needed in order to keep price pressure under control.

The Bank of England’s MPC minutes was considered to have a dovish tone and weighed on an already struggling pound. The MPC highlighted increased levels of uncertainty within global economies as a concern and a threat to economic stability and the future direction of monetary policy. Markets viewed the minutes as a confirmation that interest rate were unlikely to rise this year despite the central bank stating that medium to long term growth and inflation forecasts remained unchanged. Warnings on instability and uncertainty pertained largely to short-term factors affecting economic conditions.

UK retail sales figures dropped slightly in April adding further pressure to the pound and although sterling was able to recover slightly after public sector net borrowing showed spending in April decreased by more than what analysts had expected.

The Euro began the week depreciating further as institutional investors began to shy away from the single currency deeming EU peripheral sovereign debt as too risky an investment. The debt crisis has called into question the Euro’s appeal as a reserve currency. Reserve status has been a major support factor for the single currency in recent years.

Economic data took a bit of a back seat again this week, German PPI came out at 0.8% m/m while the ZEW economic sentiment index dropped to 45.8 from 53 and EU CPI remained flat at 1.5% in April. A more significant event was the announcement by Germany that it would temporarily ban naked short-selling and default swaps on EU government bonds. Markets took this as a sign that EU leaders were still looking for ways to control the markets while they try and sort out the debt crisis but feared the beginning of a ‘disorderly regulatory crackdown’ and the lack of clarity from EU  governments shattered market confidence. The overall trend for the euro was negative although market speculation did provide some support to the single currency. Rumours that the Swiss National Bank had physically intervened in currency market to weaken the Swiss Franc versus the Euro ignited speculation that other central banks may take similar measure to stem the euro’s decline. Finance ministers met on Friday to discuss the ongoing crisis in Europe and market confidence was boosted in the hope that discussions could result in additional support measures being introduced to help support EU member states. Profit-taking on the improvement in market sentiment helped to lift the euro off of the 4 year lows reached this week.

US economic data was predominantly on the down side and revived fears that US economic recovery could be destabilised. US PPI and CPI inflation came out lower than expected supporting the Fed’s position that no interest rate rises would be necessary in the short to medium term. Weekly jobless claims increased to 471K from 446K the week before and leading economic indicators fell to -0.1% from 1.3% m/m, the data suggests that there is still some economic weakness ahead for the US and with the European debt crisis, concern of a secondary global slump kept investors cautious. Despite the data releases the dollar continued to appreciate as safe haven flows into the greenback increased. Negative sentiment towards the euro and pound have provided little alternative to investors seeking to minimise their risk exposure to global economic shocks.

A drop in oil prices gave an added boost to the dollar this week as prices fell over 5% in a very volatile commodity markets. Supply pressure do not seem to have materialised as yet given the oil spill in the Gulf of Mexico but with the expectation that refined oil reserves will soon come under pressure oil prices could once again rise sharply.

Next Week

Sentiment is likely to remain as a driving force behind currency markets, sovereign debt and risk aversion are the two predominant factors weighing down investor confidence. As concern over sovereign debt and the effects on economic stability continue to mount, UK GDP Q1 preliminary results will be a critical event for the pound. The Bank of England minutes last week suggested a potential upward revision to Q1 GDP and should this occur the pound could recover recent losses across the board. The new UK government still has it all to prove to markets and with the Chancellor’s budget speech on the 22 June, spending and growth figures are likely to garner great interest from investors. The US has generally seen data that supports a continued economic recovery but Thursday’s US GDP release will be no less critical as the fear of contagion remains and any signs of destabilisation within the US economy could further investor concerns regarding global economic recovery. The German market holiday on Monday will have some volume impact on euro trade early in the week and could see the single currency maintain at least some of last week’s gains although risk aversion will continue to keep markets cautious.

Economic Data Releases