Forex Breaks away from Other Risky Assets During Mid East Tension

Stocks are lower again during the European session as investors continue to fret about the prospect of an escalation in Middle East tensions, especially now that protests are scheduled to take place in Saudi Arabia on Thursday. We will have to wait and see if this morning's announcement by the King of the oil-rich nation that he would boost the social security fund and create 1,500 extra jobs will be enough to placate the people and stop them from taking to the streets. But if the tensions do spread to Saudi expect oil to spike even more.

Currently the Brent Crude oil price is over $107 per barrel, if we see a sustained increase in the price of crude then this will start to have detrimental effects on growth across the world, which is bearish for equities. The market is in wait-and-see mode right now, but while uncertainty persists risky assets will trade on the back-foot.

Interestingly, forex markets haven't followed equities into this risk-off mode. The chief driver of FX remains interest rates, although the Swissie and the yen are benefitting from safe haven flows. Hence we have seen EURUSD rise back above 1.3700 and GBPUSD test 4-month highs at 1.6250 after the release of the Bank of England minutes earlier this morning. The Committee voted 6-3 to keep rates on hold; however the hawkish camp (that would like to see rates rise to crush inflation pressure) gained one more member. Spencer Dale, the Bank's chief economist, voted for a 25 bp hike at the February meeting. The minutes had a more hawkish slant to them than in the past, even though the MPC would have known that growth contracted at the end of 2010. The minutes included that some of the undecided members on the MPC felt that the upside risks to inflation expectations "had grown, given that inflation was set to be higher, and above target, for longer than previously expected." This suggests that the neutral middle is ripe hunting ground for the hawks on the Committee. The pound surged and gilt yields also spiked on the release.

Overall, the minutes suggest that the UK could see a rate hike in May as long as growth does not disappoint in the first quarter of this year. Since forex markets are hunting for yield, this is bullish for the pound. Expectations are also rising that the ECB, who meets next week, will take a more hawkish line as higher commodity prices continue to fuel inflation. Also, overall the Eurozone economy is performing extremely well led by Germany. If EU authorities can come up with a credible solution to the weak peripheral nations' fiscal issues then the ECB may not be far behind the Bank of England in hiking rates.

For now that puts the dollar on the back-foot. However, bar an oil price shock as described above, the positive outlook for the US economy could see investors turn back to the dollar after June, when the current round of QE comes to an end. Consumer confidence reached a 3-year high in February it was announced yesterday, and this added to evidence that the US does not need any more stimuli. Later this year the market will turn to focus on the Fed's exit strategy and this will boost the dollar into year-end in our opinion. For now though, it is still the ugliest of the 3- major currency sisters.

The dollar hasn't even been attracting much in the way of safe haven flows since the onset of the Middle Eastern crisis, instead investors have supported the Swissie and the yen, and we expect this dynamic to continue for as long as uncertainty grips the market.

Elsewhere, the Aussie dollar has managed to stay above parity, which bodes well. While the Kiwi dollar continues to struggle after yesterday's devastating earthquake in Christchurch. The quake has reduced the chances of a rate hike by the RBNZ, which in the current yield-seeking environment suggests that NZDUSD will be unable to stage a successful recovery any time soon.

Ahead today the focus will be on existing home sales, but mainly on Fed speakers Hoenig (non-voting hawk) and Plosser.

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