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14th December 2012
From Lloyds Bank

EZ Flash PMIs the focus – 1.3125/30 the key level for EUR/USD

ON BULLETS

• S&P cuts UK outlook from stable to negative

• China HSBC flash PMI rises to 50.9 vs 50.5 in Nov – 14 month high

• Fisher says good case can be made that a weaker pound is more appropriate

USD Although the USD remained under pressure for much of yesterday’s session, the key levels at 79.57 in the USD index and above 1.3125 in EUR/USD remained intact.

While the FX market has show a clear USD and JPY negative bias into and out of the FOMC meeting, the reaction is much less clearly being seen as risk positive in the equity market, and US yields are also generally higher. In theory today is the last day of the lame duck session in the US Congress, so the market focus on the fiscal cliff may increase.

EUR Eurozone flash PMI data should be the main focus today, with the recent better than expected ZEW data from Germany suggesting upside risks. However, unless the numbers are sharply stronger than expected, we suspect the failure to break above 1.3125 in EUR/USD yesterday is an indication that the short term risks are on the downside.

Although seasonality is favourable for the EUR through December, and forward points have moved in the EUR’s favour in the last week, they have not reached levels to justify a break to new highs. We suspect the short term market is short USD and JPY, and may square positions into the weekend.

GBP There has been a lot of talk around the potential for a change in the Bank of England’s target in recent days, with the idea of nominal GDP targeting being floated. Osborne did not indicate any such change was likely, but said the issue was open for discussion.

In practice, we doubt there will be any change, as the Inflation target itself doesn’t really restrict Bank policy, only their interpretation of it. But the talk of the potential for change is a hint of market suspicion that the BoE may turn more aggressively dovish under Carney. While the BoE might do more QE in any case, it does point towards potential sterling weakness from here.

JPY The election at the weekend is obviously the major focus, and speculative accounts are clearly going into the election short yen. There is consequently a risk of some position squaring into the weekend, as there are significant profits to be taken on long yen positions. This is much more likely if risk appetite turns more negative.

Spotlight – 6.5% unemployment rate target makes some sense – Why 6.5%? As an unemployment rate this is probably still too high to be adding any domestic inflationary pressure to the US economy. Historically 5.5%-6% has been seen as the NAIRU in the US. But 6.5% is well on the way to a level that will halt deflationary pressure on the US. As the chart below shows, it has historically been consistent with real wage growth of around -1%, which is coincidentally around where it is now.

So if unemployment were to fall to that level, it would at least suggest that there would be less reason for real wage growth to decline any further, but would not be putting any real upward pressure on inflation. At the rate seen this year, it will only take a year and a half to get to 6.5%, but it is likely that progress will get more difficult as the labour force is likely to increase more rapidly as the economy recovers.

Read the full report on Lloyds Bank website here.