Forex - RBNZ Sounds Dovish But Risk Taking Remains

Markets are trading in a lethargic manner as participants continue to nervously take on risk-correlated trades. The move toward risk is logical because without the massive sovereign crisis fear hovering over the market like the Sword of Damocles, one needs to consider the fundamentals - particularly monetary policy, as the core driver. Overall, the rate at which central banks are mopping up excess liquidity has been slower-than-expected with the BoE and Fed still discussing the potential for further QE.

In this era of ultra-low policy rates, risk taking will be encouraged. In the past few days, we’ve seen Eurozone sovereign spreads narrow considerably, the VIX index is trending lower along with decreased FX volatilities and global equity markets have demonstrated a resilience to bearish news. If corporate earnings come out strong, this could be the start of a summer rally, however we’re not so sure. Our view is that the fears surrounding sovereign risk may have subsided for the time being, but will most likely return this fall.

Even with the recent stint of positive news, foreboding signs are on the horizon. The Fed’s Beige book released yesterday reported that the US recovery remained on track but has begun to actively slow. The notion of a US slowdown was reinforced by recent US data, including yesterday’s durable goods figures.

In New Zealand, the RBNZ raised its policy rate 25 bps to 3.00% as we had predicted and the accompanying statement asserted that future growth prospects had deteriorated considerably. Traders rapidly paired down their interest rate expectations which in turn weighed on the NZD.

Governor King’s comment seemed to slam into the sterling market, which was curious because his remarks were really nothing new or original. He recommended caution over reading too much into the strong Q2 GDP figures and reaffirmed that inflation remained finely in check. Paul Fisher stated that the global outlook had weakened and David Miles resonated with the most dovish view of all – that inflation would taper off and the current ultra-loose policy was correct.

The combination of all these comments hit the GBP value like a sledge hammer. It wasn’t until Sentance’s hawkish comments that the “current policy setting was extreme” that some sanity was regained in the FX market.

We are convinced that the market is now underestimating the strength of the UK recovery and that the current downtrend in inflation will flat line and then begin to move higher. The BoE interest rate path should give GBP a boost in the mid-term.

Otherwise, there’s a frenzy of data to be released during the European session today and after that it’s onto corporate earnings. We will continue to use equity market activity as a compass for FX directions. Correlation remains particularly high between the EURUSD and S&P and should thus be traded accordingly.