Kathleen Brooks, research director at Forex.com, gives her views on the news and events affecting the currency markets.

Energy price spike leads to hunt for yield

This morning’s session feels a bit like the calm before the European Central Bank (ECB) storm that’s coming tomorrow afternoon. The market is fairly static today after the Fed minutes were released yesterday. Although the minutes showed a commitment to going the whole hog with QE2, it was an undoubtedly more bullish communication than we have seen in recent years. The Federal Open Market Committee noted that the high prices of commodities are putting upward pressure on inflation and overall conditions in the labour market 'appear to be improving gradually'.

This doesn’t mean that the Federal Reserve (Fed) will go ahead and raise interest rates once they end QE2, far from it. The minutes also noted that the housing market remains depressed and the measures of underlying inflation are still subdued. But the market is extremely sensitive to central bank action right now, so the fact that there has been a shift in tone from the Fed – albeit subtle – was enough to push Treasury yields higher and lend some support to the greenback.

Dollar strength manifested itself in USD/JPY, which rose to its highest level for more than six months. It hit 85.50, but has since retreated to the 85.00 level. There isn’t much out data-wise from the US today, so the market will concentrate on news-flow including a speech by the Fed’s Dennis Lockhart at midday BST.
 
Other dollar crosses are faring less well and the dollar index has come off since the open of the European session. EUR/USD has had a storming start to the session boosted by two factors: one, general bullish feeling in the lead up to tomorrow’s ECB meeting; and two, the weak UK manufacturing data that pushed up EUR/GBP.

The pound has had a volatile couple of days as economic data continues to give diverging signals. Yesterday’s services sector PMI for March was much stronger than expected, which spurred GBP/USD to 1.6360. Yet today we were brought back to earth when industrial production data was weaker than expected in February, falling 1.2 per cent on the month dragging the annual growth rate to 2.4 per cent from 4.3 per cent. In January. The main slump was in durable goods, while investment in the sector continued to increase. Industrial data is a good way to check the health of an economy, and right now the UK looks fairly sickly in first quarter 2011. Coupled with that, higher taxes kick in from today, which should keep the pressure on consumer confidence.

There are even reasons to doubt the sustainability of the services sector strength in the UK. Input prices rose substantially and business confidence actually dropped in March. Part of the strength may be down to activity playing catch up after weather-related disruptions at the start of the year. Short Sterling interest rate futures have also started to retreat after today’s production data.

The pound continues to remain fairly well supported especially versus the dollar, yet it is looking increasingly vulnerable versus the euro especially as we lead up to tomorrow’s ECB meeting.

There seems to be no stopping energy prices. UK oil is back above $122 per barrel, its highest level for 3-years. This adds to problems for central bankers who are trying to boost growth while trying to keep inflation expectations in check such as the Bank of England. It also makes a hike from the ECB and continued tough talk from president Jean-Claude Trichet on inflation concerns more likely tomorrow, which could boost the euro.

Oil of course may end up being a victim of its own strength. Last time prices spiked the world was catapulted into recession. We are not at those highs yet, but we are seeing companies complain about input prices which will eat into margins and could weigh on profits. This is hitting equities, which have been fairly muted in recent sessions. Inflationary fears are also fuelling strength in precious metals. As oil takes another leap higher, gold and silver follow. Gold made another high yesterday and there is little standing in its way between where it is now and $1,500 per ounce.

Rising energy prices are boosting the Aussie which is close to 1.0400 versus the dollar. It seems that interest rate differentials are the main driver of FX right now. As energy prices continue to hit multi-year highs investors want yield to counter the inflationary effects. This is good for the high yielders like the Scandi currencies, the Aussie, Kiwi and the euro. However, this hunt for yield remains negative for the Swissie and the yen, where central banks seem to be committed to keeping rates low for now. The pound and the dollar are somewhere in the middle depending on how policy pans out in the coming weeks.

This is an interesting development and we will be looking at in more detail in the coming weeks.