"God save the Queen"…BUT what about her currency?

The week ended with the Dollar recovering a bit though it still was lower against all the majors except USD/JPY and USD/CAD. The major surprise economic event for the week was the abysmal UK3Q GDP figure that was released on friday which, understandably, led to a rather severe and immediate unwinding of long cable positions across the board.

The release showed that the economy had shrunk by 0.4% when the consensus called for growth of 0.2% and left no doubt that the UK was still mired in a recession. In some ways the fact that this was a surprise, is the surprise. The global meltdown that was triggered by years of irresponsible financial practices cannot be expected to be repaired in mere months, in fact a more reasonable time frame might be set in years. With hopes of seeing actual evidence of a recovery squashed, attention quickly focused on what the BOE might do next to try and resuscitate the economy. The only viable option seems to be to increase Quantitative Easing, a practice of injecting extra funds to stimulate the economy through purchase of bonds. This throws a monkey wrench into the views of many that QE would be halted and that the unwinding process would begin in 2010. GBP/USD, which was trading at around 1.6600 prior to the release, plummeted to 1.6400 within minutes and continued its descent before closing just above 1.6300 to end the week.

This event also highlights the markets preoccupation with the inevitable tightening sequence that has to commence at some time. We have already seen Australia raise rates as apparently China’s voracious appetite for raw materials (whether they are being used or stockpiled is anybody’s guess) has led to domestic wage pressures intensifying to the point where it became absolutely necessary for the RBA to embark on this course of action. The Pound had also been strengthening over the past few sessions on the belief, aided in no small part by BOE rhetoric, that the UK was closer to raising rates than the US.

So, given what transpired Friday, the focus now shifts squarely to the US GDP figures slated for release next thursday and a positive surprise, and all that that entails, just might cause the dollar to “lose” its funding currency status to the Great British Pound. The US 10YR yield is approaching 3.5% again and that suggests that the bond market, long considered to be the “real” arbiters of monetary policy, is pricing in stronger economic data releases and the inflationary threat that such events pose. Coincidentally the dollar has been strengthening versus the Yen, the de facto proxy for risk, as US yields have been rising and that sets up what should prove to be a very interesting week as the battle between risk appetite and risk aversion rages on.

The dollar is still in a bearish trend and it should be viewed in that context until there is a shift in the US administrations policy, but this weeks price action might be signalling that the time for a short term corrective bounce for the beleaguered unit could be in the offing (of course all this assumes a normal, defined as the opposite of the blind panic seen late last year, market environment) and that there just might be a change in the “rankings” with the Great British Pound surpassing the Dollar as the least attractive currency.

If, on the other hand, the result from across the pond was a harbinger of what the US result might look like, then batten down the hatches because risk aversion, which might have gotten a whiff of a bid with the UK news, will have reared its head again, and for those who have forgotten what happens when this occurs, the chart below clearly shows the DOW-Dollar correlation in times of panic.

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