risk aversion takes a slight breather, sterling pulls back vs the EUR

EUR/USD remains confined within yesterday's ranges. The better to mixed tone of stock indices and the move by gold away from its highs is suggestive of a modest reprieve from risk aversion. It seems probable that yesterday's comforting words from the Fed's Bernanke that the US recovery remains intact will be repeated in his speech this afternoon and this may keep risk aversion contained in the next few hours.

In line with Bernanke's sentiments tonight's Beige Book may also provide evidence of economic recovery in the US. That said the market will not shrug off scepticism about the strength of the US upturn until jobs data show a decent improvement. Also set to carry on weighing on sentiment are worries about sovereign default risk which continue to be reappraised by investors.

High levels of debts and deficits and the negative connotations for growth from the inevitable fiscal repair process will continue to undermine growth potential for many industrialised economies and this will also limit potential for a significant recovery in the risk trade.

Sterling recovered the better part of yesterday's losses against the EUR this morning even though UK April export data failed to provide improvement long hoped for. While sterling was sold on yesterday's comments from Fitch that the UK fiscal challenge is 'formidable', the reaction appeared to be overdone.

S&P  provided a similar warning thirteen months ago and in the intervening period the problem of the UK's huge budget deficit has been widely publicised. Not only that but the new UK coalition government has been busy in the past few weeks warning the electorate of spending cuts that will be felt for decades. Not everyone is convinced that deficit reduction is the appropriate policy for the slow growing UK economy with ex-MPC member Blanchflower today warning of the risks of double dip recession but the markets are clearly demanding action.

Insofar as the government is apparently committed to deficit reduction starting with the June 22 budget, the outlook for gilts and the pound has improved. Given that sterling is still 21% weaker vs the EUR than its average level of 2007, the downside bias in EUR/GBP is likely to persist and upticks could be good sterling buying opportunities.

Swiss National Bank Reserves data imply that fx interventions last month were substantial. The SNB may be worried about negative implications of the strong currency on growth potential but Q1 GDP growth rose a very respectable 2.2% y/y and while CPI is still subdued there is speculation that the SNB may revise higher its inflation outlook.

Given that the attraction of decent Swiss domestic fundamentals are underpinned further by safe haven demand for CHF in light of sovereign debt concerns in the Eurozone, it seems likely that the downtrend in EUR/CHF will continue for the time being. Support at EUR/CHF1.3715.

No policy chances are expected from either the BoE or the ECB tomorrow. However, the RNZ may announce a 25 bp rate hike. This will not guarantee a sustained positive reaction for the NZD, however, given the current reluctance of investors to stack up on risk.

The speech by Bernanke and the Fed's Beige book are the key events this afternoon.

Jane Foley

Research Director FOREX.com jfoley@forex.com +44 207 398 5024