This Week's Market Outlook : The never-ending consolidation is about to end

Highlights

• The never-ending consolidation is about to end
• Most medium-term concerns about the US dollar are overblown
• ECB rate decision outlook
• Key data and events to watch next week

The month of June has been characterized by a seemingly endless consolidation in both USD-currency pairs and in many cross-currency pairs as well, not to mention stocks and other major asset markets. Looking back, it's perhaps easiest to view the consolidation in terms of investor risk appetites and the stabilization in the global downturn. Since March, generally less-worse data has seen risk appetites improve, leading to substantial gains in risky assets like stocks, commodities, and, in FX, higher JPY-crosses and a weaker USD. In June, the optimism over the near-term outlook gave way to the realism that major economies were simply stabilizing at extremely low levels and that any recovery or outright growth was months away and likely to be anemic at best. And it was that tug-of-war between optimists and realists that played out in the form of the choppy consolidating price action we have experienced.

Over the course of the past month, we have been of the view that the realists would eventually win out and that risk aversion would return more forcefully, leading to a stronger USD, weaker stocks and commodities, and lower JPY-crosses. Along the way, numerous red-herrings were thrown on the trail, most of a USD-negative nature (e.g. end of the USD as the global reserve currency; US deficits, loss of US AAA credit rating), which distracted us from the ongoing sentiment-driven environment. Returning to that focus--investor sentiment--is the key to anticipating the next directional move in FX, we think. In light of the relatively minor pullback seen in risky assets overall, and with incoming data continuing to suggest stabilization over relapse, we think the optimists are more likely to win the tug-of-war with the realists. As such, we are now more biased toward another surge in risk appetites, leading to a renewed slide in the USD and a further advance in the JPY-crosses and gold. While we stick to the views that fears over a USD implosion are without basis (see below), and that the US economy will fare better than other major economies, the Eurozone in particular (see below), we have to reckon that those themes will come into play only later this year. In the near-term, then, we prefer to sell the USD on strength while the current consolidation persists and buy JPY-crosses on weakness within recent ranges.

From a technical view, we are increasingly convinced that the current consolidation represents a messy 4th wave in a five-wave decline in the USD, with the last wave down yet to come. Should the fifth wave materialize, we don't expect it to be especially substantial or long-lasting, which comports to our longer-term view that USD strength will return later this year. Additionally, several key risk markets, gold and the S&P 500 in particular, survived tests of their Ichimoku clouds, which are now key support levels. In concrete terms, EUR/USD could see gains into the 1.47/48 area on strength over 1.4250/4300; GBP/USD could see 1.74/75 on strength over 1.6600; USD/CAD could see a return to the 1.05/1.08area; and USD/CHF could see back to 1.05/1.06, SNB intervention notwithstanding. USD/JPY is likely to see less overall weakness if we are correct, and may only slip back to 92/93. In this environment, it seems easier to know when you're wrong than when you're right, so we will be closely watching the following daily close (5 pm NY) levels as a signal to abandon the view in favor of risk appetites: S&P 500 close below 880/890; EUR/USD below 1.3750; GBP/USD below 1.6150; USD/CAD above 1.1700; USD/CHF above 1.1200; gold below 925/930.

As with all good consolidations, this one too shall eventually end. Next week stands out as an appealing window of opportunity. In addition to being month/quarter/half-year-end, where fresh portfolio adjustments may trigger a break, next Friday is likely to be an exceptionally thin holiday market ahead of the US 4th of July holiday. FX markets have a nasty habit of breaking out around US holidays, when only the US is celebrating (e.g. 4th of July or Thanksgiving). A potential catalyst may be the June NFP report on Thursday, which if the NFP change shows further improvement as expected, and possibly coupled with initial claims dropping below 600K, could embolden risk appetites and see the risk-rally re-ignite. Other stand-out potential catalysts are the Japanese Tankan survey and the Chinese manufacturing PMI, both on Wednesday morning in Asia. As always, with range consolidations we are wary that the first side to break is frequently the wrong side, typically followed by a quick reversal and break of the other side of the range, which is why we concentrate on daily closing levels. Month/quarter end flows are likely to keep the price action choppy and seemingly inexplicable, but ultimately provide patience with opportunity.

Most medium-term concerns about the US dollar are overblown

If past is prescient, a US credit downgrade would do little to the perceived riskiness of US government assets. Among the top 10 economies in terms of nominal GDP Japan, Italy and Spain have all fallen from the coveted AAA perch (according to Standard and Poor's ratings) in recent years and this has had little impact on the relative rate at which they were able to float government paper. Usually when the perceived risk of an asset rises, investors will demand a higher rate of return in order to compensate for that risk. The facts on the ground suggest the impact from moving down a notch in the ratings environment is negligible. Italy and Spain lost their AAA status back in May 1998 and the spread between their 10-year government debt yield relative to the US (the de facto risk-free asset) actually narrowed by 50 basis points within the following 12 months. Japan was knocked down from AAA in February 2001 and six months later its spread to US 10-year paper was only about 10 basis points higher. It was back to pre-credit downgrade levels within 12 months. More recently, Spain lost its AAA rating in January 2009 and its 10-year yield differential to the US has narrowed a massive 90 basis point - so much for greater perceived riskiness. If this is any indication of what the market reaction will be in US yields from a rating downgrade, it seems we are making a big fuss about nothing.

When it comes to the issue of foreign reserves, much has been made about the US dollar potentially losing its premier status in this space. While we believe this will be a long and drawn out process of diversifying away from the US dollar, we also find it interesting to see what the implications would be. The best example we have of this in recent memory is the Japan experience. The yen's share of global reserves has been on a secular decline and has dropped steadily from around 7% of total global allocated reserves in 1995 to near 3% in 2008. One would think, given the reaction in the USD every time its reserve status is questioned, that this diversification away from yen would have proved detrimental to the currency. The reality is actually much different. During that same 1995-2008 period the value of the trade-weighted yen (a weighted basket of currencies of Japan's main trading partners) rose a massive 25%! So when it comes to the US dollar, the impact from a lower global allocation is likely a touch exaggerated to say the least. While knee-jerk reactions will undoubtedly continue to play out in the short term (witness the dollar-weakness on the latest China call for a super sovereign currency), the medium-term implications for the buck from more diversification in global reserves is likely to prove less than significant.

Last but not least, we would be remiss not to mention the unfounded concerns with regards to US funding needs. While budget deficits and government spending look to remain at astronomical levels, confidence in the ability of the US to pay its debts remains unshaken. The fact that the US economy is one of the most productive, enjoys unparalleled political stability and account for a massive 25% of global growth is not lost on the investor community. The proof was in the pudding this week when despite a record $104 billion in Treasury note issuance, demand looked to be near all-time highs. What was even more reassuring is that the longer-dated of the three securities on offer actually garnered the most appetite. The 7-year note auction was well oversubscribed with the total number of bids outpacing the amount on offer by 2.82 times. This was the best bid/cover in the security's short history and well above the average 2.35 seen over the last three offerings. What was more impressive is that indirect bidders took 67% of the amount rewarded. Indirect bidders are a proxy for central bank demand and this suggests that all of the talk about foreign governments diversifying away from US assets has yet to be substantiated. We wonder aloud why foreign officials continue to talk down US assets in public even as they buy them hand-over-fist behind the scenes.

ECB rate decision outlook

The next ECB policy meeting is scheduled for July 2. The ECB is expected to maintain its current degree of enhanced credit support but no change in policy is likely either in rates or in unconventional policy measures.

The enormous size of the ECB's first ever 1 year loan auction on June 24 has reduced the potential for any shocks from upcoming ECB meeting. The ECB first announced that it would extend the term of funding to 12 month on May 7, but the size of last week's auction was a surprise. Demand was underpinned by a revival in speculation that the ECB is unlikely to push the refinancing rate below its current 1%. This was partly the result of comments from the ECB's Weber earlier in the week that the ECB has 'used' its room to cut interest rates. In total, the ECB last week lent EUR442 bln in its one year tender. It seems inevitable that the sheer size of the liquidity injection should help keep short-term rates low and enhance credit availability within the broader economy, but the ECB's reaction to the auction will be closely examined in next week's post policy meeting press conference.

The ECB also announced in May that it plans to buy EUR60 bln covered bonds (due to commence in July). This is more similar to the quantitative easing adopted by central banks such as the Fed and the BoE. However, the size of the plan is small. Clearly the ECB intends to continue concentrating its effort to restore liquidity in the money market. Insofar as growth is not expected to reappear in the Eurozone until 2010 there is little danger of the ECB withdrawing its 12 month or 6 mth tender in the immediate future though, in tune with the ECB's anti-inflation credentials, following the 12 month action last week the ECB's Stark stated that the measures adopted will be unwound swiftly and the liquidity absorbed when macroeconomic conditions improve.

The EUR has not shown clear signs of being depressed by the ECB's huge injection of liquidity. However, it seems that the ECB is intent on keeping short term rates low, a view which is supported by the lack of inflation in the region (German June CPI flat y/y). On balance, therefore ECB policy is consistent with the view that the EUR will struggle to make headway against other currencies in the weeks ahead.

Key data and events to watch next week

The data calendar in the US is packed despite a holiday-shortened week for equity and bond marts. Tuesday kicks it off with the Case-Shiller home price index, Chicago PMI and consumer confidence. On Wednesday we get the ADP employment report, ISM manufacturing, construction spending, pending home sales, weekly crude oil inventories and auto sales. Thursday is the highlight with nonfarm payrolls, initial jobless claims and factory orders all on deck.

The eurozone is a touch less busy. Monday starts off the week with eurozone consumer confidence. French producer prices and German employment are due Tuesday while German retail sales are on deck Wednesday. The highlight of the week comes Thursday with the ECB rate decision (analysis above) while Friday rounds out the week with eurozone PMI composite and retail sales.

Japan is on the lighter side. Industrial production is out on Sunday along with retail trade. Monday has the employment report while Tuesday sees small business confidence and the highlight of the week, the Tankan industry surveys.

The UK has some top-tier numbers lined up. The Hometrack housing survey starts things off on Sunday. Monday has net consumer credit and consumer confidence due up. Home prices and GDP are scheduled for Tuesday while Wednesday sees PMI manufacturing. Friday ends the week with the PMI services report.

Canada is super light and the only noteworthy events are industrial product prices and GDP, both on Tuesday.

The action down under is pretty average. New Zealand trade balance and building permits are first up on Sunday. Tuesday is busy with New Zealand business confidence, Australian new home sales, Australian private sector credit and Australian performance of manufacturing index. Wednesday has Australian retail sales on tap and the Australian trade balance closes out the week on Thursday.

Also worth mentioning are important events in Switzerland and China. SNB Governing Board Member Thomas Jordan is due to hold a speech on Thursday and given the recent interventions by the SNB in the FX market, this could prove market moving indeed. China sees PMI manufacturing on Tuesday and a better than anticipated number could give risk assets a shot in the arm.

Brian Dolan, Chief Currency Strategist Jacob Oubina, Currency Strategist Forex.com http://www.forex.com

DISCLAIMER: The information and opinions in this report are for general information use only and are not intended as an offer or solicitation with respect to the purchase of sale of any currency. All opinions and information contained in this report are subject to change without notice. This report has been prepared without regard to the specific investment objectives, financial situation and needs of any particular recipient. While the information contained herein was obtained from sources believed to be reliable, author does not guarantee its accuracy or completeness, nor does author assume any liability for any direct, indirect or consequential loss that may result from the reliance by any person upon any such information or opinions.

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Weekly Economic and Financial Commentary

U.S. Review

Clawing Our Way Back

We have often noted the road to recovery would be long and arduous. The most recent batch of economic data supports that notion. Better news in one area continues to be tempered by setbacks elsewhere. This week's pleasant surprise was durable goods orders, which showed more strength and breadth than expected. That gain was offset by mixed data on home sales and a rebound in unemployment claims.

We still expect the recession will end this summer. Second quarter real GDP likely declined at close to a 3 percent annual rate, with most of that drop coming from a plunge in inventories. Third quarter real GDP is expected to rise solidly, with a rebound in motor vehicle production and slight improvement in consumer spending providing much of the boost to output. The largest boost to third quarter GDP, however, will come from a reduced pace of inventory liquidations.

Sales of existing homes rose 2.4 percent, while sales of new homes fell 0.6 percent in May. Sales have stabilized recently and look as though they have bottomed. Even the hardest hit areas of the country are noting some improvement.

Excesses are Gradually Being Eliminated

Even though new homes sales declined 0.6 percent, excesses are being cleared out of the market. Construction has pulled back even more than sales, which has led to a steady decline in inventories. Inventories of unsold homes have fallen by 161,000 over the past year and are now back near the lows seen in the late 1990s, which was before the housing boom began. Of course, there are still plenty of nearly new homes in existing home inventories. Many of these homes have never been lived in and are giving builders stiff competition for the few buyers that are in the market right now.

Personal income jumped 1.4 percent and after-tax income rose 1.6 percent. Disposable income was boosted significantly by the American Recovery and Reinvestment Act. Consumer spending rose 0.3 percent in May. The gain was slightly less after adjusting for higher inflation, with real personal consumption expenditures rising 0.2 percent. That gain follows declines during the previous two months. Real personal consumption outlays are currently running at a 0.5 percent annual rate below its first quarter pace. Even if spending rises by another 0.2 percent in June, the second quarter will still see a slight decline in real consumer outlays. Another gain, however, would set the third quarter up for a solid increase and bolster our forecast for third quarter real GDP growth.

The weekly first-time unemployment claims data continue to be the most important real-time information we get on the economy. This past week saw initial claims rise a surprising 15,000 to 627,000 and the previous week's number was revised up by 4,000. The closely watched four-week moving average and continuing claims also increased. In addition, several states noted that education services accounted for a large portion of recent claims. That last note caused many folks to downplay the increase. The layoffs, however, reflect serious financial strains at private schools, colleges and universities and public schools. These layoffs are real and present a growing threat to the recovery.

The jobless claims data provide us with much of the information needed to estimate nonfarm employment and the unemployment rate. We expect nonfarm payrolls declined by around 420,000 jobs in June, while the unemployment rate likely rose to 9.6 percent. Labor force growth will have more influence on the unemployment rate over the next few months, as recent college graduates join the workforce and teenagers and college students search for summertime jobs. The annual influx often leads to wide swings in the employment and unemployment data, particularly when we are around key turning points in the business cycle.

U.S. Outlook

Consumer Confidence • Tuesday

Primarily lifted by increasing expectations that the end of the recession is likely coming to an end sometime in the second half of this year, consumer confidence has more than doubled from the record low set in February. While we are calling for economic growth, and thus an end to the recession, to resume in the third quarter, we believe there will be a slight pullback in consumer confidence for the month of June. Stock prices are slightly higher, on average, when compared to May but have cleared slowed. Gasoline prices, while well below last year's level, continue to climb as we enter the summer driving season. Lastly, the unemployment rate continues to rise towards double-digit levels as job creation in many industries remains scarce.

Previous: 54.9 Wachovia: 49.5 Consensus: 55.2

ISM Manufacturing Index • Wednesday

The Institute for Supply Management's headline manufacturing index rose to an 8-month high in May signaling that the prolonged contraction in the factory sector could be coming to an end in the not too distant future. Much of that optimism comes from the forward-looking new orders index which jumped above the expansion/contraction line to 51.1 in May – marking the first time it has crossed into expansionary territory since November 2007.

We believe the recent upward momentum in the headline index should continue in June as several regional purchasing managers' indices, notably the Philadelphia and Richmond indices, have shown significant improvement. As always, the employment index will be closely watched and should register a modest gain with manufacturing activity beginning to bounce off recessionary lows

Previous: 42.8 Wachovia: 43.5 Consensus: 44.0

Employment Report • Friday

Despite the decreasing nonfarm job losses over the past few months, firms are still cutting workers at an uncomfortably elevated pace. We expect to see a modest pullback in June with nonfarm payrolls declining around 400K. If realized, job losses in the second quarter (at a -416K average) would be significantly lower than the first quarter (-691K average) confirming recent signs of stabilization we have seen in the broader economy. Reflecting that optimism is the recent improvement in temporary help. Temporary help employment, which has historically been a leading indicator of improvement in the labor market, fell only 7K in May versus an average decline of 62K over the past three months.

The unemployment rate should continue to drift higher, albeit at a slower pace than we have seen over the past 6 months. Our call is for a two-tenths percentage point increase to 9.6 percent. Unfortunately double-digit unemployment is not too far away.

Previous: -345K Wachovia: -400K Consensus: -370K

Global Review

Signs of Global Stabilization

Over the last several weeks, economic developments around the world have shown that the freefall in activity that followed the financial crisis last fall is showing signs of moderation. This week was no exception and purchasing managers in the Euro-zone are beginning to take heart that the worst of this global recession may finally be in the rearview mirror. While the early "flash" readings of Euro-zone Purchasing Manager Indices (PMIs) for June showed a small down-tick for the services component, it also registered a substantial improvement for manufacturing. The composite index for all industries rose to 44.4 from 44.0. This is still below the key "50" level which means the current conditions are still reflective of a period of contraction. It is the highest reading, however, since last September (before the Lehman bankruptcy) and suggests that the

Euro-zone is now contracting at slower pace and the economy is stabilizing. We estimate that real GDP in the Euro-zone contracted at roughly a four percent annualized rate in the second quarter, which is not quite as bad as the 9.5 percent drop registered in the first quarter. While growth may remain slightly negative in the third quarter, real GDP should start to grow again, albeit at a sluggish pace later this year. Other measures of business sentiment corroborate the story of improvement in the economic picture. In Germany, the Ifo index - a key yardstick for business confidence - improved for the third straight month. While German businesses did not note any improvement in their current assessment, expectations for business performance in the next six months jumped to 89.6, the highest reading since last summer.

Sentiment is Improving as Global Recession Loses Steam

French business confidence also increased for the third-straight month in June. President Sarkozy recently announced a roughly €30B stimulus package which includes tax cuts and spending projects to help lift France out of recession. Businesses are not the only ones feeling encouraged; French consumer sentiment also increased in June, marking the fourth consecutive month of improvement for that series. Consumer sentiment is now the highest it has been since March of last year. There is a growing outlook that this global recession is losing steam. Italian business sentiment is also improving, but a recent report suggests that rising unemployment is keeping a lid on wage growth.

Domestic demand is also weak in Japan, where data released this week showed further contraction in imports. May imports fell 3.6 percent. The trade balance showed a ¥222B surplus in May, the second monthly increase. Exports to the U.S. market and Europe continued to decline as did exports to the rest of Asia. While Japan's May exports fell in nominal terms on a seasonally adjusted basis, on a volume basis they actually showed growth. Real export volumes rose a seasonally adjusted 1.8 percent for the month of May after a 1.0 percent gain in April. The current global recession has been as challenging in Japan as it has been anywhere in the world. These recent improvements in export volumes are welcome developments for Japan, where foreign trade is critically important to the health of the overall economy.

Global Outlook

German Unemployment Rate • Tuesday

Economic growth in the Euro-zone's largest economy contracted at a 14.4 percent annualized rate in the first quarter of this year as Germany weathered the slowdown in global demand that followed the financial crisis late last year. Industrial production data are still declining at a double digit pace, suggesting the economy still faced headwinds in the second quarter. That said, recent improvement in business sentiment and early signs of recovery in global trade have offered some hope that the pace of decline is slowing. German employers have had to scale back production and let go of workers in recent months. However, fewer people lost their jobs in May than any other month since last October, suggesting a welcome slowing in the rate of job losses. Still, with industrial production falling so swiftly German employers will have more cuts to make before this recession has fully run its course. The consensus expectation is that the unemployment rate climbed slightly in June.

Previous: 8.2% Consensus: 8.3%

Japanese Tankan Survey • Wednesday

Some market watchers have used the word "depression" to describe the economic situation in Japan. With real GDP contracting at more than a thirteen percent annualized rate in each of the last two quarters, one can understand why. The collapse in global trade, made worse by last fall's credit crunch, rocked the Japanese economy. Indeed, real exports of goods and services crashed at an annualized rate of 70 percent in the first quarter.

In the global review section of this report, we discussed the recent improvement in exports. That improvement has fueled hopes for a turnaround in the Japanese economy. The Tankan index of Japanese business sentiment plunged from a reading of -24 in the fourth quarter of last year to -58 in the first quarter, edging out the all-time low set in the deep recession of 1975. As the nearby chart shows, the Tankan tracks closely with GDP. The consensus is expecting a relative improvement in the second quarter when this number prints on Wednesday.

Previous: -58 Consensus: -34

U.K. Purchasing Manager Indices (Wed.-Fri.)

Real GDP in the United Kingdom contracted at an annualized rate of 7.3 percent in the first quarter, the sharpest rate of contraction since the third quarter of 1979. But purchasing managers' indices (PMIs) have recovered in recent months. In fact, the services PMI is above 50 for the first time since April 2008. The manufacturing and construction PMIs are moving in the right direction but still remain firmly in contraction territory.

In the second half of next week the PMI reports will be gradually rolling in. On Wednesday, manufacturing PMI is expected to show modest improvement, but will likely remain below 50. Construction PMI is reported on Thursday; little change is likely for this series as homebuilders in the U.K. try to gauge whether or not the real estate market has bottomed. Finally on Friday the services PMI prints, and markets will watch to see if the series remains over 50.

Previous: Mfg. 45.4, Construction 45.1, Services 51.7 Consensus: Mfg. 46.4, Construction 46.0, Services 51.5

Point of View

Interest Rate Watch

Economy Dictates Steady Fed Policy

This week's statement from the Federal Open Market Committee focused on two fundamentals. First, the FOMC stated that "information received suggests that the pace of economic contraction is slowing." We concur. Second, the FOMC stated "the Committee expects that inflation will remain subdued for some time." We concur again. Thus, our outlook remains unchanged - the range for the Federal funds rate will remain steady for the rest of this year.

Our view that the funds rate would remain unchanged received additional support from the Fed's announcement on its liquidity programs. This announcement follows up on the comments of Bill Dudley, President of the New York Fed, which suggest there will be no rapid drop-off in the Fed's support. The Federal Reserve extended commercial paper and primary dealer facilities suggesting the Fed wants to keep these just in case the expected recovery runs into problems and/or some unexpected end-of-year complications develop. Extending these programs until February allows the Committee to review all programs at their semi-annual outlook session.

The limits on the asset-backed commercial paper and term securities programs were lowered but appear generous relative to recent usage. As for the Term Auction Facility (TAF) the Fed argued that bid amounts at recent auctions had fallen below the auction amounts. This suggests that interest right now is limited and this allows the Fed to reduce the amounts going forward. We view the lowering of these limits as a sign of policy success and not a restraint on the marketplace. To the extent private investors, not the Fed can maintain an orderly market the better off the economy becomes.

Topic of the Week

Recession Probability Still Declining

Economic recovery prospects have improved. The probability of recession two quarters from now has downshifted sharply over the previous three months. The latest probability calculation from our quarterly recession model is consistent with prior economic recoveries. The second quarter reading currently stands at 37 percent, down significantly from the 80 percent readings registered earlier this year. Our model takes a look at a very broad set of variables, and the results suggest economic recovery is likely within the next six months.

Economic improvement began to show up in our model in recent months in the regional Chicago manufacturing survey. While the official recovery call will come from the National Bureau of Economic Research, our outlook is that the recovery will begin in the third quarter of this year with economic growth increasing around a three percent annualized pace.

While we do expect recovery in the pace of economic growth, employment remains an issue for both cyclical and structural reasons. Job declines have been widespread with major losses in manufacturing and construction. The only bright spot recently has been healthcare and education. Aggregate hours worked in the U.S. economy have declined in recent months suggesting continued weakness in both employment and hours worked.

Moreover, the structural trend of declining employment in blue-collar manufacturing continues as it has since the early 1970s. These declines reflect the high cost of labor relative to capital that has prompted the increased use of technology and capital to substitute for labor, as well as the evolution of consumer demand from "goods" to "services."

Wachovia Corporation http://www.wachovia.com

Disclaimer: The information and opinions herein are for general information use only. Wachovia Corporation and its affiliates, including Wachovia Bank, N.A., do not guarantee their accuracy or completeness, nor does Wachovia Corporation or any of its affiliates, including Wachovia Bank, N.A., assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sales of any security or any foreign exchange transaction, or as personalized investment advice. Securities and foreign exchange transactions are not FDIC-insured, are not bank-guaranteed, and may lose value.

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The Weekly Bottom Line

HIGHLIGHTS OF THE WEEK

• Bond yields pulled back, as inflationary fears continue to abate
• U.S. durable goods for May improved for second consecutive month - especially in core capital goods
• New home sales fell in May but existing home sales see second month of advance, with months of inventory easing
• Fed left rates unchanged and stayed silent on "exit strategy", but highlighted disinflation pressures from widening slack and, on Thursday, modified several of its programs
• Canada's pace of growth for Employment Insurance beneficiaries slowed in April and the number of new claims fell, but job losses appear to have accelerated during May.
• The retreat in Canadian home prices steepened in May, according to a quality-adjusted measure of real estate vallues
• S&P/TSX buffeted by dampened expectations for the global economy, following a sobering World Bank report, but index recovers ground by week's end

UNITED STATES - FRAGILE BOTTOMING CALLS FOR A FINE BALANCE

U.S. economic data continued to show signs of tentative stabilization this week; but, with debate now focusing on the future exit strategy, markets should heed that whatever current buoyancy exists owes strongly to fiscal and monetary intervention. The training wheels, provided by monetary pump priming, ultimately need to come off, and markets have upped pressure on central banks to deliver coherent strategies for withdrawal of monetary stimulus. However, risks of a renewed period of weakness are ignored one's at peril. Prudence requires a careful balance between "not too soon nor too late". With the World Bank's economic outlook on Monday observing significant weakness in emerging markets, markets got some cold water poured on their hopes of a quicker-than-expected global recovery (though, as we point out in a commentary, the estimates are not that different from the IMF's earlier view when calculated with comparable weights).

Happily, with a $104 billion in supply of 2-,5- and 7-year Treasuries this week (a record weekly issuance), the auctions were well-received. Moreover, as inflationary fears have subsided, the resulting fall in bond yields is a positive sign. In congressional testimony, Ben Bernanke further countered inflationary concerns: "The key issue here is can we unwind this money creation and low interest rates in time to head off inflation when the economy begins to recover? We have all the tools we need to do that. We believe we can do that. We will certainly remove that stimulus in time. And we are committed to price stability and we will make sure that it happens."

Walking the tightrope, the Fed's rate decision on Wednesday was a near mirror from its April announcement, holding rates steady and emphasizing its view for near-term disinflation, as growing "resource slack is likely to dampen cost pressure." While still silent on an exit strategy, the statement noted that the Fed is "monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted." Indeed, the Fed's balance sheet shrunk again in the latest week to $2.010 trillion from $2.056 trillion - the lowest level since the Fed ramped up monetary injections in March. With bank access to liquidity having stabilized, Thursday saw some re-tooling of the Fed programs, with some facilities scaled back and others extended, with the aim of easing credit more directly for households and businesses.

In further positive news, U.S. housing markets continued to show signs of bottoming, with existing home sales in May rising for a second consecutive month and the inventory of unsold homes (at the current pace of sales) improving to 9.6 months from 10.1 months in April. Distressed properties constituted 33% of sales, but this is down from 45% in April. While foreclosures continue to weigh on housing markets, the degree of crowding-out may be abating.

The week concluded with an ostensibly improved U.S. report on personal income and outlays for May, which showed a second consecutive month of gains in both disposable income (PDI) and the underlying personal incomes. Nonetheless, with wages still falling, the monthly gain in personal income (+$167 bn at seasonally-adjusted annual rates) owes almost entirely to government transfers (+$163 bn), while PDI was further augmented by a $20 bn reduction in personal taxes. Strengthening PDI also seems to have stimulated some spending, and durable goods spending saw its first monthly advance since January. However, uncertain U.S. households are stowing precautionary cash: savings rates rose from 5.5% in April to 6.9% in May - the third month of heightened savings and the highest savings rate since December 1993.

CANADA - ROADBLOCKS FOR THE CANADIAN CONSUMER

A Canada Day weekend crisis was adverted in Ontario, as the threat of a liquor store strike led to nothing more than panic buying at most stores across the province. If only avoiding the fallout from the global recession was that easy. Aside from the one-day alcohol shopping spree in Ontario, the global turmoil has taken a large toll on Canadian consumer spending, and even with the worst likely behind us, the data this week proved that consumers still have many challenges to overcome.

A key challenge has been the deteriorating financial situation of Canadian households. The combination of stock market turmoil and declining home prices dragged net worth down in the first quarter of 2009 for a third consecutive quarterly loss. The cumulative loss of $510 billion is the largest three quarter decline on record and was enough to wipe out the prior two years of wealth gains. The good news is that there have been some improvements since the end of the first quarter. Despite a temporary dip below 10,000 earlier this week over concerns about a tepid U.S. recovery, the S&P/TSX index has risen 18% from end of March levels, and 34% from its low. Looking ahead, equities are likely to experience some further volatility in the near future, but mid-single digit gains in corporate profits in 2010 should support higher market values. Nonetheless, it will take years to fully recoup the losses racked up since the stock market's recent peak in 2008.

On the housing front, the Canadian Real Restate Association (CREA) has provided some encouraging signs with existing home prices increasing marginally over the first few months of 2009. However, an alternative measure for tracking home prices, the Teranet home price index (which adjusts for the quality of homes being sold), has contracted at an accelerated pace since October, and in April the index dropped to the lowest level in two years. The disparity between the two measures of real estate values suggests that the rise in existing home prices has been due to greater sales volumes of "higher end" homes, as well as heightened sales in higher priced regions. For the majority of Canadians, home values are continuing to deteriorate.

Consumers will not be gaining any support from the labour market either. We learned this week that the amount of people receiving Employment Insurance in Canada edged up 2.7% in April, while the amount of initial claims fell. This should come as no surprise, as April was the month when the job destruction took a small break. But, the job losses continued in May, and the upcoming labour force report is expected to reveal that the Canadian economy shed a further 35,000 job losses in June bringing the job loss tally to 400,000 for the current recession. TD Economics expects a near 500,000 jobs to be lost before the recession ends, with the unemployment rate reaching a ten-year high of 10%. Even with the support from employment insurance benefits, the tightness in the labour market dragged personal disposable income down 2.3% in the first quarter of 2009, as wages fell for the first time on record. Although the decline in income will end in the coming quarter, the recovery in personal income growth will be subdued.

As the economy heads down the road of recovery, consumers will follow, but cautiously. The damage to the household balance sheet caused by lower asset values and weaker incomes will take time to repair, and, during the period, consumers will continue to scale spending growth and increase savings. We do expect a consumer recovery by the end of the year, but growth will not return to trends witnessed over the last decade.

U.S.: UPCOMING KEY ECONOMIC RELEASES

U.S. ISM Manufacturing Report - June

• Release Date: July 1/09
• May Result: 42.8
• TD Forecast: 46.0; Consensus: 44.0

After struggling under the weight of the ongoing intense global economic recession for close to two years, it appears that the winds are slowly shifting in favour of the U.S. manufacturing sector. Indeed, after reaching a multidecade low of 32.9 in December, the ISM manufacturing sector index has steadily clawed its way back. This upward momentum is expected to gather further steam in June, with the index expected to surge to 46.0. The key factor underpinning this call is the surprisingly strong gains in the new orders component of the index, which has moved above the all-important 50 threshold in May for the first time since November 2007. The new orders to inventory spread, a useful proxy for the future direction of manufacturing sector production, has also risen sharply in May, adding further strength to our call. Further evidence of the recent resuscitation in new orders was also seen in the new durable goods orders report for May, which showed the first monthly back-to-back gains since the middle of last year. Notwithstanding this improvement in June, with the economic backdrop for U.S. goods producers remaining very dire, we expect manufacturing sector activity to remain weak for some time, even though the pace of decline should continue to ease as the headline ISM manufacturing sector index continues its march towards the allimportant 50 threshold.

U.S. Nonfarm Payrolls - June

• Release Date: July 2/09
• May Result: -345K; unemployment rate 9.4%
• TD Forecast: -300K; unemployment rate 9.7%
• Consensus: -375K; unemployment rate 9.6%

The U.S. labour market remains mired in a prolonged downward spiral, as businesses continue to shed jobs at a high clip in the face of the ongoing intense economic recession. In fact, since January last year, over 6 million jobs have been lost, and there is no indication that the layoffs will end any time soon, even though the pace of job destruction has continue to easing - after peaking at 741K in January. In June, we expect a further 300K jobs to be lost. This will be the fifth consecutive monthly fall-off in the number of jobs being eliminated from the U.S. nonfarm payrolls. Evidence of this improved tone in U.S. labour market conditions can be seen in the weekly jobless claims reports, which have shown both initial and continuing claims falling below their recent peaks. As has been the case in the past, the losses are likely to be split almost evenly among the goods-producing and services-producing sectors. In terms of the unemployment rate, with the pace of job destruction continuing to outpace job creation, the unemployment rate should rise even further, climbing to 9.7%.

CANADA: UPCOMING KEY ECONOMIC RELEASES

Canadian Real GDP - April

• Release Date: June 30/09
• March Result: -0.3% M/M
• TD Forecast: 0.1% M/M
• Consensus: -0.1% M/M

As a small open economy, with significant exposure to U.S. economic activity through trade and financial sector linkages, the Canadian economy has been dealt a severe blow by the ongoing intense U.S. economic recession. In particular, Canadian economy activity declined for a record eighth straight month in March, taking the value of Canadian economic output back to their November 2006 level. This freefall, however, is likely to be interrupted in April, with the Canadian economy expected to post its first monthly gain since November, with a modest 0.1% M/M advance. Most of the gains are likely to come on account of the modest bounce-back in tourism, manufacturing sector activity and wholesale sales during the month. Retail sales and construction activity should be sources of drag on overall economic activity. Notwithstanding the expected respite in April, the Canadian and global economic fundamentals remain extremely weak, and as such, we fear the downward trajectory in Canadian GDP could return.

TD Bank Financial Group

The information contained in this report has been prepared for the information of our customers by TD Bank Financial Group. The information has been drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does TD Bank Financial Group assume any responsibility or liability.

READ MORE - The Weekly Bottom Line

Forex Forecast of Major Currency Pairs

GVI Forex Trading Points -

June 28, 2009

-- Financial markets seem to be in the midst of a crisis of confidence as they probably got well ahead of the pace of the global economic recovery, which is going to take time.

-- Markets moving away from risk assumption posture.

-- Ultimate outcome of Iranian elections still up in the air.

USD:

-- Latest Fed Statement takes a slightly more hawkish tone. No rate hikes in the cards yet.

-- Employment data on Thursday likely to show May improvement was partially a statistical fluke. Employment loss on the order of -450K would not be surprising.

-- Recent improvement in the tone of the bond market bears scrutiny. 4.0% in the 10yr note is the pivotal level.

JPY:

-- Declining trade surplus reduces capital export (JPY positive).

-- Deflationary pressures persist.

-- Economy bottoming.

Click on chart for two year history

EUR:

-- EUR/USD 1.40 the tipping points for the markets.

--.Key ECB meeting is on Thursday. They talk tough but have badly overestimated the strength of EZ economy. Watch what they do more than what they say.

-- Tight EUR/USD to S&P correlation has been working only intermittently.

Click on chart for two year history

GBP:

-- UK economy still weak but bottoming.

-- Brown government in crisis. Could fall at any time. More conservative government could be seen as GBP positive.

Click on chart for two year history

CHF:

-- SNB concerned about weakness of the economy, but CHF tied to EUR.

-- Expect SNB intervention at any time to hold EUR 1.50 line vs. EUR.

Click on chart for two year history

Business Cycle Trades:

-- CAD, AUD and NZD business cycle trades come into favor when markets in risk assumption posture.

-- Crude $70 line pivotal

John M. Bland is an author and co-founder of Global-View.com. Prior that, he was a senior forex dealer in a subsidiary of the Continental Grain Company in NYC. Previously, he was a member of the Chemical Bank corporate advisory service in NYC. He also worked in international liability management. John holds an MBA from the Hass School at the University of California at Berkeley and a BA in Economics from Berkeley.

READ MORE - Forex Forecast of Major Currency Pairs

Weekly Focus: The Tide has Turned

Global update

• The upward revision of OECD's global growth forecasts marks a turning in the tide. Over the past two years all revisions have been to the downside. Going forward we expect more upward revisions as we are still more positive than consensus and the international organisations.
• US data confirms a picture of improvement. Capital goods orders were stronger than expected and home sales and house prices show signs of stabilisation. A rise in jobless claims cast some doubt over the recent improvement in the labour market, though.
• Euroland Flash PMI and German ifo rose further in June, suggesting that the pace of decline in Euroland production is tapering off. Leading indicators point to further improvement going forward.
• Asian export data add further to the picture of a brisk recovery in the Asian economies.

Market movers ahead

• A busy week ahead with US ISM and nonfarm payrolls taking centre stage. We look for further improvement in both.
• The ECB meeting on Thursday will be the main event in Euroland. We don't expect much change in the rhetoric, though, and the meeting could become a non-event. Euroland Flash CPI and M3 are also due to be released.
• In Denmark focus turns to Danish currency reserve data and first quarter GDP. We expect the currency reserve to be broadly unchanged at the current very high level.
• In Sweden focus turns to the Riksbank meeting and PMI while Norway releases retail sales, PMI, unemployment and credit indicator.

Global update: The tide has turned

The tide has turned in forecast revisions

After two years of constant downward revisions, OECD this week delivered its first upward revision of global growth in its Economic Outlook (see table). For the US, China and Japan, growth was revised up by around one percentage point, while Euroland growth was on balance unchanged as growth was seen as being weaker in 2009 but slightly stronger in 2010. The revision comes after several months in which data have been stronger than expected and the financial crisis has eased. OECD also changed its risk assessment as it now sees risks as balanced in contrast with the previous risk assessment where risks were seen to be strongly on the downside.

OECD has moved closer to our own growth estimates but is still more pessimistic - especially for 2010. The difference mainly comes from a different interpretation of how the inventory cycle has worked in this downturn compared with previously. OECD leans towards the IMF approach in comparing this downturn with previous downturns in which financial crises have played a significant role. History tells you these are normally long and deep.

We believe, though, from looking at the data, that companies have responded much faster in reducing inventories compared with previous crises. Both because the magnitude of the crisis was a big surprise for most companies but also due to a strong need to raise liquidity as a direct result of the crisis.

In order to reduce inventories, production has to be cut back sharply in order to fall below actual demand. Demand is thus met mostly by delivering goods from the inventory while production is more or less shut down for a period. This took place in late 2008 and early 2009. However, now that inventories have been depleted, demand can no longer be met by taking goods from inventory. Hence production has to rise again. And this will lead to a production rebound in H2 09 - even if demand only rises slowly (for more on our forecast see Global Scenarios, June 2009). We believe OECD underestimates this inventory effect and it will affect mostly H2 09 production numbers. But as production rises in H2 09 it will have a higher starting point in 2010 and it will mostly show up in the 2010 forecasts for which we are more optimistic. If we are right, this will not be the last upward revision from OECD.

Data picture improving slowly but surely

Overall data continues to support the recovery story. US capital goods orders rose more strongly than expected in May and seem to have stabilised in the past two to three months after a massive collapse in H2 08 and early 2009. If indeed capital orders are stabilising this is earlier than expected as investments are normally a late-cycle demand driver. Data on US home sales also gave further evidence that sales are starting to stabilise. And several house price statistics released this week point to some stabilisation in house prices - or at least that the pace of decline is slowing. Throwing some doubts into the equation was a rise in US jobless claims the past week. Although the data is volatile, the latest data point suggests a more slow process of improvement in the labour market.

In Euroland, surveys from PMI and Germany's ifo institute generally continued the picture of further improvement. And looking at the inventory-order balance taken from the PMI statistics the situation of improving orders and lean inventories points to a fairly strong production rebound in H2 (see chart).

Asian data continue to look strong. Japanese exports rose strongly in May (when measured in volume) and data for South Korean exports in the first 20 days of June support the picture of a sharp turnaround. Asia has recovered briskly from this crisis and will be a strong force in turning the global trade collapse. In Europe for example 20% of exports go to Asia and these exports are likely to rise strongly over coming quarters after being in freefall over the past two to three quarters.

Market movers ahead

Global

• US: Focus in the coming week will be on non-farm payrolls and ISM. The May employment report took markets by surprise with a much smaller-than-expected decline in payrolls. Labour market indicators received so far point to another positive surprise in the June employment report. We expect job losses to have moderated further and look for a decline in non-farm payrolls of 270,000. The ISM manufacturing index for June is expected to rise further as signalled by several regional PMI indices. Combined with the continued decrease in US credit spreads and the huge gap between demand and production, we look for an above-consensus increase to 46.5.
• Europe: The main event will be the ECB meeting but we do not expect any major changes in signals from the ECB as it has adopted a wait-and-see stance. Rates are likely to be kept on hold for a long time. Euroland M3 and Flash CPI are also due to be released. In the UK PMI is expected to rise further.
• Asia: Focus will mainly be on Japan, where we expect data to confirm our view of a sharp rebound in growth. As signalled by corporate production plans we expect industrial production in May to show a new record monthly increase in industrial production. Production plans for June and July released in connection with the industrial production figures will give an idea of how much further production will rise in coming months. Tankan business confidence will reflect the recent improvement in the Japanese economy and rebound significantly in Q2. However, it will probably show that corporate capital expenditures remain the weakest link in the Japanese economy. With industrial activity increasing fast, manufacturing PMI should jump above 50 in June. In China we expect the two manufacturing PMIs to confirm increased momentum in industrial activity.

Scandi

• In Sweden the Riksbank meeting and the situation in Latvia take centre stage. The Riksbank might follow the ECB and announce a longer-term tender. In Norway retail sales, unemployment and the credit indicator are due to be released. Overall we look for more improvement in data. In Denmark we expect a broadly unchanged currency reserve. Danish Q1 GDP will show a significant decline - as seen in most countries.

Financial views

Equities

We maintain a positive view on equities in the medium term. Risk appetite has returned and our five point trigger list (from February 2009) for a stock market recovery has almost been completely fulfilled; we are consequently looking for new triggers.

To underpin further market recovery in the coming months, we are looking for (a) final demand pick-up, (b) coverage of underweight positions, (c) mid-cycle valuation focus, and (d) weaker deflationary impulses.

Fixed Income

Global: The rising trend in bond yields is expected to continue on a three- to six-month horizon based on continued improving macro conditions, increased risk appetite and heavy supply. The US is expected to underperform Euroland.

Intra-Euro: We are neutral in peripherals (Italy, Greece and Spain) versus Germany. On longer maturities, we still prefer France and Finland to Germany. We are long 5Y Austria against Spain. We are long 10Y Ireland against 10Y Denmark.

Scandi: We are underweight 10Y Danish government bonds against Euroland and swaps, but overweight 2Y Danish government bonds. We are overweight Swedish government bonds versus Germany in the 2Y area. We have closed our long position in the long end of the NOK government curve relative to Germany. We are overweight on Danish 30Y callable mortgages bonds versus both swaps and government bonds. We remain underweight in non-callables versus government bonds apart from 4'10.

Credit

During the past couple of months credit has enjoyed a very strong spell across the sectors and capital structure and spreads have tightened significantly. At the same time the activity in the primary market continues to be at a record high as more and more companies turn to the capital markets instead of the banks for funding. The ongoing strength in the primary market is a consequence of an asset allocation shift into credit, we believe.

We question the pace and sustainability of this massive rally and in recent weeks sellers have re-emerged in the credit market putting CDS spreads under some pressure. The macroeconomic outlook is still challenging and defaults are currently increasing. A while ago we moved to overweight based on the large liquidity and risk premiums for credit. Both these premiums have now been reduced substantially and we therefore recommend a neutral positioning.

FX Outlook

EUR/USD is set to adjust lower in the short run, but to continue upwards in the medium term. Important drivers for EUR/USD are equities as a proxy for risk and most recently oil prices. EUR/GBP is heading down as sterling is supported by positive economic data and a normalisation in financial conditions. Carry can keep on performing, while funding currencies will face headwinds.

Swedish krona and Norwegian krone both have solid potential against the euro. Currently, however, risk aversion and event risks (watch out for the Riksbank meeting 2 July) are still too high to see the Scandies exploit their full potential. The Danish krone is attractive (e.g. against Swiss franc) due to sound carry.

Commodities

The rally in commodities seems to be running a bit out of steam with oil having a hard time trading significantly above USD 70 a barrel.

We think a short-term risk of a correction is growing. In our view, the market is neglecting near-term weakness such as weak oil demand and huge stocks in base metals. However, in six months' time, we expect a new leg up in prices when the different market balances are expected to tighten for real.

Foreign exchange: Big events, limited effects

Central banks centre stage yet again

Central banks were in the spotlight once again in currency markets during the week, but there were no really big direct FX implications. The EUR strengthened slightly against other currencies. The coming week brings a raft of interesting events.

As expected, the Federal Reserve decided to leave its key rate unchanged at 0.13%. More important was that the bank did not announce further purchases of government bonds and also toned down its deflation fears. The USD strengthened slightly ahead of the meeting, but generally there was a relatively small reaction in FX markets compared with previous meetings. The Fed kept its cards close to its chest in terms of future actions, giving no clear signals about an exit strategy from its quantitative easing, which means that the USD is still in the danger zone in terms of the Fed's monetary policy.

The result of Wednesday's record-large 12-month tender at the ECB is worth noting as it may effectively act as a rate cut. More than 1,100 banks took the opportunity to borrow funds, and the ECB ended up lending no less than EUR442bn at a rate of just 1%. We consider the whole operation a work of genius. The ECB will probably now succeed in getting interest rates to stay low for longer and stimulating the economy without the bank 'getting its hands dirty', as it does not itself need to commit to direct purchases of government bonds à la Federal Reserve and Bank of England. Were the ECB itself to buy up government bonds in Euroland, it would face the tricky decision of where these should be from, whereas now the banks themselves can decide whether they want to buy, say, German or Italian debt.

We cannot completely rule out the possibility of recent weeks' EUR strengthening actually being related to this tender, as some investors have acquired EUR assets for use as collateral. However, the money now released can be expected to be invested in assets denominated in other currencies, which may mean less support for the EUR ahead. However, we do not expect this to be the dominant factor: against the USD, for example, the EUR is still most dependent on movements in equity and oil prices.

Key events for FX markets in the coming week

There are a variety of events that may have FX implications in the coming week. All retail sales data need to be kept an eye on, as weaker-than-expected figures could knock sentiment in the markets, pull down equity prices and undermine pro-cyclical currencies like the AUD, NZD, SEK and NOK. Tuesday's US consumer confidence data and the Chicago PMI may also be important pointers for risk appetite during the week. Wednesday brings PMIs across Euroland, and the ISM survey in the US will also be followed closely. Generally analysts expect the rebound to continue, but in smaller increments. It is important in this context to note that all of these indices in the western world are still indicating a decrease in output.

Key events of the week ahead

• Retail sales data
• Euroland PMIs and ISM
• SEK: Riksbank meeting (Thursday 9.30)
• USD: Employment report (Thursday 14.30)

Full Report in PDF

Danske Bank http://www.danskebank.com/danskeresearch

Disclaimer

This publication has been prepared by Danske Markets for information purposes only. It is not an offer or solicitation of any offer to purchase or sell any financial instrument. Whilst reasonable care has been taken to ensure that its contents are not untrue or misleading, no representation is made as to its accuracy or completeness and no liability is accepted for any loss arising from reliance on it. Danske Bank, its affiliates or staff, may perform services for, solicit business from, hold long or short positions in, or otherwise be interested in the investments (including derivatives), of any issuer mentioned herein. Danske Markets´ research analysts are not permitted to invest in securities under coverage in their research sector. This publication is not intended for private customers in the UK or any person in the US. Danske Markets is a division of Danske Bank A/S, which is regulated by FSA for the conduct of designated investment business in the UK and is a member of the London Stock Exchange.

READ MORE - Weekly Focus: The Tide has Turned

Financial Markets Review : UK Bond Yields and Swaps Fall

Financial market review - foreign exchange

Momentum in the pound has faded somewhat this week amid mixed economic data and Bank of England Governor King's concerns over the magnitude of the UK fiscal deficit. After recording a high on Monday (€1.1904), £/€ pulled back to close the week at 1.1738. £/$ traded the week in the 1.6210-1.6602 range, closing today at 1.6505. Volatility levels continue to gradually fall in foreign exchange as the USD remains stable and range-bound. This stability is shown in today's close in the USD index, of 79.9, which is less than 0.2% away from the close 5 week's ago. AUD/USD and NZD/USD are relatively unchanged on the week, reflecting the small movement across commodity prices. Crude oil fell by only 1.2% this week. This has helped to keep the oil price sensitive currency pair, USD/NOK, stable over the week. The Swiss National Bank has intervened aggressively in the foreign exchange market to depreciate the Swiss franc. The SNB widened their stance to intervene in both EUR/CHF and USD/CHF. The SNB have not formally announced an explicit level which they would like to defend, instead expressing a desire to reduce excessive strength and volatility in the currency. However, intervention has occurred frequently as EUR/CHF approached SFr1.50. The SNB is likely to continue regular interventions to weaken the franc (which is being supported by the nation's current account surplus) whilst fighting deflation in Switzerland.

In emerging markets, the Colombian peso has been the worst performing currency against the USD. Concerns that the economy may be weaker than expected alongside the government's announcement of a larger fiscal deficit continue to provide a significant headwind for the peso, which has depreciated by 2.4% this week, following last week's 4.5% decline. The Brazilian real closed the week at 1.9473, strengthening 1.4% against the USD. Brazil is the world's largest exporter of sugar and the recent rise in sugar prices, which hit a 3-year high amid concerns of a poor crop in India, have been supportive of the real. China has renewed its call this week for a supersovereign currency and that the SDR basket should be broadened. Such announcements by China continue to have a short term negative impact on the USD.

It has been a relatively quiet week for UK data, dominated by the CBI distributive trades report. The reported sales index remained unchanged, at -17, in June providing a little disappointment to the market. US data have been more mixed. The Richmond Fed manufacturing index rose again and the latest durable goods orders report indicated another solid rise in orders over May. On the flip side, existing and new home sales were reported below market expectations. These mixed data helped to keep the USD in its current range.

The Federal Reserve announced that the Fed Funds Target Rate would remain unchanged at 0-0.25% and that the quantitative easing programme would continue within the existing parameters. The FOMC statement contained only a few subtle changes from the previous statement and as such only provided short term support for the USD. 2-year interest rate spreads between the Eurozone & US as well as between the UK & US have also been relatively stable over the week, allowing EUR/ USD and GBP/USD to hold in ranges over the period.

Interest rate market review - bonds, cash and swaps

Strong demand at UK gilt and US treasury auctions, lower equity markets and a successful ECB one-year liquidity operation bolstered government bond markets and caused yields to fall along the curve. A change in language on inflation in the Fed FOMC statement briefly caused some profit taking, but yields subsequently resumed their decline to reach a 3-week low. Gilt yields also fell after BoE governor King and the Bank's Financial Stability Report warned that the financial system remains vulnerable to shocks and that the stabilisation of the economy could easily stall if lending to households and businesses does not improve. A sharper decline in short-term vs long dated yields in the UK caused the curve to steepen. Yield curves in the US and the euro zone flattened.

Except from BBA May mortgage approvals data on Tuesday and the CBI distributive trades survey on Thursday, there were no major UK data releases for markets to trade on. Mortgage approvals rose above 30,000 for the first time since April 2008, reaching 31,162. The CBI reported unchanged retail turnover in June vs May, but a further decline in inventories in Q2 could have implications for growth in the second half of the year. A rise in consumer demand could force retailers to increase inventories which in turn could boost GDP.

Solid follow through buying in short-dated fixed income paper squeezed UK, US and euro zone yields markedly lower over the first part of the week. UK 2y gilts yields dropped 19bp over the first three days to a intra-week low of 1.12% on Wednesday, outperforming US treasuries and German bunds. In their testimony to the House Select Committee on Wednesday, BoE governor King and other MPC members warned that a recovery in the UK economy would be a ‘long, hard slog'. Governor King also hinted that the MPC could raise interest rates before it starts unwinding QE. The £4bn 2022 gilt auction on Thursday was covered 1.69 times, below the 1.80 average of the past two auctions. The BoE will buy £6.5bn of gilts under the APF next week, pushing the sum of purchases since March over the £100bn mark. 5y swaps ended the week 8bp lower at 3.60%. 3-month Libor fell 5bp to 1.20%.

In the US, follow-through buying from last week helped treasury yields to extend their decline. A decline in oil prices below $68, and a combination of weak existing homes sales data and lower equity supported the fall in yields ahead of the Fed FOMC meeting. The Fed left interest rates on hold at 0.25% but made a subtle change to its assessment of inflation enough to trigger profit taking in longer dated bonds and cause yields to back up. Deflation is no longer rated as the main threat by the Fed, but the view that inflation is likely to stay subdued and the commitment to keep interest rates low should help to keep yields capped at a time that the Fed continues to make treasury and MBS purchases. A worse than expected outcome for weekly initial and continuing claims helped treasury yields to resume their decline on Thursday, despite a 2% rally in the Dow and S&P. Strong demand for the three treasury auctions ($104bn in total) and impressive overseas bidding helped to allay concerns about diversification of overseas dollar holdings and underscored the fact that a spiralling US public deficit and treasury issuance are (so far) not dampening demand for US debt. With no treasury supply scheduled for next week and participants preparing for the June employment report, bonds should continue to attract decent levels of support. 5y swaps fell 30bp to 2.92%.

The ECB eased credit conditions on Tuesday when it offered 441bn euros in one-year liquidity to 1,120 banks. This helped 3-month libor to fall 8bp this week to 1.15%, posting the biggest decline vs UK and US equivalents. Weaker than expected flash PMI data for services sector activity fuelled concerns about the path to economic recovery. This helped to push 2y bunds yields below 1.30%, capping a drop of 48bp since June 11bp. 5y swaps closed 7bp lower at 2.88%.

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READ MORE - Financial Markets Review : UK Bond Yields and Swaps Fall