Sterling breaks above $1.95

Sterling broke through the $1.95 level for the first time in two years nearing its December 2004 high of $1.9550, beyond which the way will be open for an assault on the $2.00 level, as a plunge in U.S. durable goods orders for October kept the dollar under heavy downard pressure.

Relatively high-yielding sterling was among the main winners amid the dollar’s broad selloff but was also supported by positive sentiment provided by merger and acquisition activity.

Spanish utility Iberdrola on Tuesday agreed to pay 12 billion pounds in cash and shares for Scottish Power. While the deal was clearly more EUR/GBP related, news of M&A flow that has been supportive over the last year helped GBP across the board yesterday. Even slightly dovish talk from the OECD over the UK economy failed to hold the pair back.

The OECD revised down its U.K. GDP forecast to 2.6% for 2007, from 2.9% in September and this year’s growth is seen at 2.6% as well (versus 2.8% earlier). 2008 GDP is estimated to hit a very robust 2.8%, but the organisation still claimed that no further rate hikes were necessary.

The FED’s hawkish stance has inverted the money market and the bond yield curve. With US economic data expected on the weak side, analysts at BNP Paribas see eroding US rate expectations as the main reason for further USD weakness.

Yesterday’s data provided further evidence that the US economy was slowing but with more chances of a prolonged slowdown than what was previously believed by the market to be a soft landing.

Japanese industrial production surprised on the upside by rising 1.6% m/m in October (expectations were for a 0.4% m/m decline). The market took this as a sign that December’s Tankan survey (to be released December 15) would signal strong corporate sentiment and hence allow the BoJ to hike by end year. On the back of this, the JPY gained ground across the board especially with EUR/JPY nearly reversing all of its gains from yesterday. Although BNP Paribas analysts believe that USD/JPY should keep broad pressure on the downside, they are more doubtful of EUR/JPY and hence see downside to be limited for now. Investors are likely to see pullbacks as a good buying opportunity.

Note that European government and ECB officials have shown no concerted concern over the strength of the EUR and unless central banks decide to intervene or the ECB reduces its rate hike rhetoric, we see little in the way to stop EUR/JPY from rallying further.

Rebounds in the USD yesterday proved modest and the USD continues to trade on the back foot. Tough Fed talk failed to sway the market from its current negative view on the major currency. Fed Chairman Bernanke signalled that the housing market yet poses downside risks to economic growth, but he was reluctant to abandon references to further policy firming, calling inflation ‘uncomfortably high’ and recognising that failure of inflation to moderate would be ‘especially troublesome’. Fed’s Plosser said more hikes may be needed and Poole said it would be difficult to decrease Fed funds at current inflation levels.

US data releases overnight support the view of a more prolonged economic slowdown in the US against what the market had believed to be a “soft landing”. However, a few weeks ago tough Fed talk would have overshadowed the negative data releases and the USD would have been supported. Now, the FX market seems to be moving in line with what the bond market has been trying to signal for some time. The inversion of the yield curve is an indication that the growth outlook is a lot drearier than the FX market had anticipated and investors are appearing to increasingly second guess the Fed’s assessment. In fact, the Fed might be facing a risky proposition as the market could judge the FOMC as keeping rates higher than appropriate and for longer than necessary. Downside risks remain for the USD with Q3 GDP and the Beige Book released today followed by the ISM manufacturing survey on Friday.

Finance Ministry sources say that Germany’s budget deficit should shrink to 2.1% of GDP in 2006 and to 1.5% in 2007. This would be the first time since 2002 that the deficit has come back in line with the EU limit. The improvement is not simply based on spending cuts but also a jump in tax revenues owing to an improving domestic economy.

 

Yaun gains

The yuan meanwhile rose to the highest since China ended its decade-old link to the dollar after U.S. Treasury Secretary Henry Paulson said gains will help resolve “tension” in the trade relationship.

Some U.S. officials have blamed the undervalued yuan, which boosts Chinese exports, for the loss of American manufacturing jobs and their widening trade deficit.

The yuan gained 0.1 percent to 7.8358 against the dollar, the strongest since the end of the fixed exchange-rate in July 2005, according to data compiled by Bloomberg.

A rising yuan helps to slow exports and prevent China‘s record trade surplus from pushing up the country’s foreign- exchange reserves. The central bank buys dollars to maintain the value of the Chinese currency.