Hometrack’s housing survey, thinner trading volumes and a reduction in risk aversion buying of the US dollar allowed the pound to recover some of the previous week’s losses incurred when Fitch downgraded Spain’s credit rating from AAA to AA+ on the back of sovereign debt and financial stability concerns. As UK and US traders returned from the holidays and normal market volumes returned the pound appreciated as they reviewed Monday’s house prices data that showed prices in May increase 2.0% y/y, up from 1.8% previously. UK PMI manufacturing for May remained at 58 against a forecast of 57.5 which aided the pound but it was the announcement by Prudential that it would be abandoning its $35.5bln takeover bid for AIG’s Asian operations that pushed the pound to a 3 week high versus the dollar. Currency hedges that had been placed when the deal was originally floated were unwound as the flows were no longer required. The remainder of UK data was broadly supportive for sterling although risk aversion continued to put pressure on cable. UK Mortgage approvals rose 49.9K from 49K in April and PMI construction increased to 58.5 from 58.2  in May. Nationwide house prices later in the week indicated a slight drop in monthly price changes coming out at 0.5% from 1.1% in May and combined with risk aversion to pull the pound lower as the week closed out.

Market fears were somewhat alleviated by the announcement from Greece of 3 rounds of deficit reduction measures to be implemented this year after Spain’s rating downgrade last Friday.  It was not all plain sailing though, Italian jobless figures showed an increase in joblessness in the EU’s 4^th biggest economy while the ECB issued a warning regarding EU bank debts. The European Central Bank said that EU banks faced up to €195bln in a ‘second wave’ of potential losses over the next 18 months and that write downs could be larger if heightened sovereign debt risk and the impact of government belt-tightening dragged down economic growth for the region. Comments from ECB member Noyer prompted further EUR selling. Noyer commented that EUR/USD exchange rates were not unusually low and that the purchasing power of the single currency is optimally protected as the ECB is obligated to ensure price stability. He also noted that it would take some time for confidence to be fully restored.

Economic data from Europe is not lending itself to being overly reassuring EU economic and consumer sentiment came out lower, German retail sales figures y/y dropped to -3.1% from 3.7% previously and EU retail sales followed suit dropping to -1.5% from 1.3% y/y in April. Not all data weighed on the euro though, German PMI manufacturing weakened in line with expectation, EU unemployment figures improved and EU PPI came out higher than expected at 2.8% y/y. The main supportive element for the euro came from the release EU GDP y/y Q1 that showed growth increase to 0.6% from 0.5% which is above analysts’ forecasts. On balance the euro cannot seem to come out from under the pressure of the current debt crisis and suffers from any hint of local or global economic weakness.

The dollar gave up some gains in the early part of the week as confidence was restored and investor risk appetite improved and profit taking gave the euro and the pound opportunity to recover losses. Sentiment remains the driving force behind the dollar and although economic data came out mostly positive the impact of the figures was dependent on the level of risk aversion. Improved US ISM manufacturing and construction spending weakened the dollar as risk appetite increased. Similar effects were seen from the release of the ADP employment figures and ISM Non-manufacturing data, which remained steady at 55.4 in May . Employment figures were the main focus for traders this week and the ADP employment report showed an increase of 55K which was lower than expected and cast some doubt over the large increase that was expected from the Non-farm payrolls but the headline figures was still an improvement on the previous release and kept the dollar to the lower end of the weekly ranges.

Risk aversion on Friday pushed the dollar sharply higher erasing all of the dollar previous losses and allowed it to extend gains versus the euro. US Non-farm Payrolls came out at 431K, up from the previous290K but lower than the consensus forecast of 520K, the unemployment rate dropped to 9.7% in may. Despite still being a good figure the general disappointment and the resultant shift in focus back to dent issues in preparation for next week saw the dollar reach a new 4 year high against the Euro.

Next Week

The effects of risk aversion due to the EU debt crisis and fear of contagion, not only to other countries but to the financial sectors as well, is likely to continue to support safe haven flows into the US dollar. Economic data releases are expected to provide direction for markets but within the confines of the current risk averse climate gains on positive data may very well remain limited. Central banks will dominate most of this week as both the European Central Bank (ECB) and the Bank of England (BoE) release their respective interest rate decisions. Neither bank is expected to make any adjustments to interest rates and the BoE is further expected to leave the value of its asset purchase scheme unchanged at £200bln. For the euro, market interest will lie in the ECB’s continued response to the European debt crisis and whether the central bank will take any further measures or comment on further assistance to support EU member countries. The US Fed releases its Beige Book report, an assessment on the state of economic conditions in the US, which is unlikely to significantly alter the recovery outlook for the states. On the economic data front UK retail sales and the trade deficit release will be the main focus for local traders as concern remains over debt levels in Britain and a knock-on effect from Europe.

Economic Data Releases