The dollar traded mixed on Thursday as Fed comments indicating the possible threat of deflation competed with lower jobless figures to make the markets indecisive. The Fed comments came after US government bond yields had contracted towards the level of Japanese bond yields, following a negative Fed statement that essentially lowered the US growth forecast, downgraded inflation prospects and recognized the depressed state of the US housing market. There was also a change in the dynamics of dollar demand and risk aversion as the dollar failed to benefit from the negative global economic outlook as it had before. Some commentators have argued that the dollar has stopped being the currency of choice for safety plays and is being replaced by the yen, the pound or the Swiss franc, which have all shown signs of greater resilience recently. Both sterling and the Swiss franc have also continued to rise sharply against the euro, unlike their US counterpart. It could be difficult for the dollar to sustain its advance without a yield advantage which now looks an increasingly distant prospect. Additional disappointment for the dollar came this week as China failed to allow its currency to rise as many expected. Falling confidence in the dollar also comes as policy differences between the US and most other members of G20 widen. While the Obama administration is keen to ensure recovery through further fiscal stimulus and expansion, most euro-zone countries are now going the other way, cutting spending and raising taxes in an effort to reduce record high budget deficits. Fiscal expansion is an option only for the US given the global importance of the dollar and the US Treasury market. The dollar closed Thursday’s session up against sterling at $1.4935 but down against the euro at $1.2333.

   The euro rose against most of its counterparts as economic data showed a surprising rise in French consumer spending in May. Although starting the day weak and hitting an 18-month low against the pound amidst euro-zone periphery concerns, it later rebounded as economic data from France showed an increase above the expected in consumer spending from -1.3% last month to 0.7% in May. However many analysts are calling for an end to the euro’s rally, citing the severe and continued weaknesses in the Greek debt market despite the implementation of the European stabilization programme. One leading market strategist said: “although the European Central Bank’s debt purchase programme is still in place, it is apparent that its efforts are not supporting the market in the same manner they did when the programme was first launched last month.” Moreover the worsening picture in Greece was not contained but had been accompanied by similar weakness in other euro-zone periphery debt markets. Nevertheless the euro was up against the dollar on the day, reaching $1.2333 and against the pound to £0.8256.

   The pound took a pause from its recent rally as enthusiasm for the budget and the hawkish BOE minutes waned. A warning to banks from the BOE highlighted the problem of bank financing and the credit squeeze in international money markets and put the pound under further pressure. The central bank also highlighted the risks of UK banks dealing with "European banks that have direct exposures to countries facing increased sovereign risks". Now that the budget has been fully digested critics are beginning to voice their opinions. One Liberal Democrat MP, Simon Hughes has already voiced concern over the extent of the cuts and has questioned the much touted ‘fairness’ of the budget. Not only is there a risk that the austerity program will split the finely balanced coalition, however, but also that it might unleash the ire of public sector unions. The speed of the squeeze could also substantially slow the UK's economic growth forecasts which has already been marked down to 2.3% from 2.6% next year – and could fall even shorter. If so, any chances of monetary tightening will go straight out of the door and investors may withdraw support for the pound. One critic painted the following picture: "It is not hard to imagine an infernal combination in which UK economic stalling, budget deficit overruns, public sector strikes, squabbling within the coalition, and new monetary "stimulus" by the Bank of England, produce an almighty run on the pound." The pound paused on Thursday dropping down to $1.4935 against the dollar and ¥133.82 against the yen.

   The yen rose as consumer price index figures released showed deflation slowing more than at any time in the last year, but the yen continues to benefit from safe haven demand and a weakening of sentiment for the dollar. The yen gained to ¥89.60 against the dollar and to ¥110.51 against the euro.

Analysis prepared by:

Joaquin Monfort
Forex4you analyst