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There is a growing sense that the underlying dynamics of FX markets are changing this month and in quite a decisive way. Whilst it still seems that investors are keen to diversify away from the dollar and retain an underlying preference for the euro, there appear to be strains on both sides of the relationship. For the euro, there is the sense that the main driver of Q1 performance (namely rising interest rate expectations) is waning at the same time that the dynamics underlying the dollar are also shifting. Monday was the third consecutive positive day for the dollar, rising 2.7% over this period. Changing interest rate spreads still matter for currencies, but investors are being forced to face up to issues that could have been ignored for most of the year to date, such as sovereign risk in the eurozone, the bubble-like conditions in some commodities and higher inflation rates in many Asian countries.

Guest post by FXPro


China trade surplus bounces back in April. After a couple of months of deficits, China’s trade numbers bounced back decisively in April, the headline surplus coming in at USD 11.42bln. This was on the back of a 29.9% rise in exports, with imports rising 21.8%. The figures come ahead of a slew of Chinese data early tomorrow, including inflation numbers. After the 5.4% increase seen in March, there are rumours of a 5.1% increase in the April data. Data releases, especially CPI, have proved to be somewhat ‘leaky’ in recent months, so this is probably worth taking note of.

Strength in UK retail sales should be taken in context. The BRC like-for-like measure rose 5.2% in April, following a 3.5% decline in the previous months. This volatility alone tells us that it should be taken with a pinch of salt. The timing of Easter invariably has an impact, but another factor cited this month was the extra bank holiday which boosted sales of garden furniture and Champagne. The BRC still stresses that underlying conditions continue to feature “climbing costs and depressed consumer spending”.

Trouble and strife for the euro. Early in the afternoon session, the single currency rolled over once more as the trickle of negative news that has been seeping out over recent days took its toll. There is a sense that Europe’s response to the debt crisis is now verging on the shambolic. For its part, the currency seems unsure of where it should be headed. The interest rate support that was there consistently over previous weeks has been put into some doubt by a more nuanced stance from the ECB; the situation in Greece, Ireland and Portugal is only getting worse and traders and hedge funds remain extremely overweight at a time when some may consider reducing their risk exposure. At the same time, the German export machine is still powering ahead. It should not be taken for granted that, after last week’s spring clear-out, the euro will naturally head back to the highs of a week ago.

The dark side of Greek debt restructuring. The latest downgrade for Greece from S&P (from BB- to B) is no real surprise given the current situation, but is another nail in the coffin of debt sustainability. At the same time, Moody’s has placed Greece on review for a possible downgrade. On one level, the requirement for Greece to restructure its debt is something of a no-brainer. In 2010, of the funding it undertook, the average cost (weighted) was 4.3%. On its outstanding stock of debt, it is paying around 5% on a similar basis (because the majority was issued before the situation really deteriorated. If Greece was going to return to the market tomorrow, it would have to pay three to five times this amount to issue debt, depending on where on the curve it issued and provided there was anyone out there to take it at those levels. At around 7% of GDP, interest payments are nearly three times the eurozone average. On the wider issue, Greece is stuck between a rock and a hard place, because Greek banks will take the biggest hit from any restructuring. In turn, the ECB (Greek banks having borrowed EUR 94bn from the ECB) will take a hit on a major restructuring. Remember that last year’s stress tests showed Greek banks holding predominantly (and in some cases, exclusively) Greek government bonds on their balance sheets. So, whilst on a stand-alone basis a restructuring looks like the correct course, the ramifications will likely create fresh problems that will require fresh solutions. The worrying aspect when Lehman collapsed was that it was such inter-dependencies that were a feature of the financial system. The feeling that we’ve not moved on is uncomfortably strong.

Germany’s incredible export strength. Germany’s trade sector is delivering breathtaking growth. In March, exports surged by another 7.3% to EUR 98.3bn, a record monthly outcome. In the past fourteen months, exports are up by 55%. As a result, the trade surplus has expanded, to EUR 18.9bn in the latest month, the third highest on record. Over the past year, Germany has registered a trade surplus of EUR 157bn, which represents around 6.7% of GDP! Interestingly, imports are also booming, up another 3.1% in March to a record monthly total of EUR 79.4bn. Over the past twelve months, imports have climbed by 17%. As speculation mounts regarding a possible debt restructuring for both Greece and Ireland, Germany is just going from strength to strength. Thus far, it appears that Germany’s export machine has been relatively unaffected by the appreciation of the euro, although this will bear close scrutiny over coming months.