Euro, US Equities Prove Unable To Sustain Bounce

Highlights

US dollar was mostly softer vs. the majors, with EUR/USD trading above 1.20 briefly before falling back late in the day on US equity weakness.  Bounces remain hard to sustain, so once this period of consolidation ends, we see euro weakness resuming.  Yen was mostly firmer and outperformed the buck and so dollar/yen fell back towards 91.  EM FX was mostly firmer as some risk appetite returned, but the equity sell-off late in the day bodes ill for risk on trades near-term.  Biggest gainers on the day vs. USD were CLP, COP, RUB, GBP, and NOK, while only losers vs. USD were KRW, PLN, ZAR, INR, and NZD.

US equity markets were lower, as DJIA, S&P, and NASDAQ ended down 0.4%, 0.6%, and 0.5%, respectively.  European markets were higher, with Euro Stoxx 50 rising 1.8%.  Asian equities are likely to open down today as Asian ADRs were lower during N. American trading Wednesday.  Nikkei futures point to an up open for Japan, but the firmer yen should hurt Japan exporters.

US bond market up, as 2- and 10-year yields down 2 bp and 1 bp, respectively.  US 10-year auction mixed, as bid-cover rose (3.24) but indirect bidders (40.2%) fell.  European bond markets mixed too, as 10-year yields in UK, France, and Germany up 6, down 1 bp, and up 5 bp, respectively.  Greek 10-year yields rose 2 bp, Portugal rose 1 bp, Ireland flat, Italy fell 15 bp, and Spain fell 2 bp.

Currency Markets
Fed Beige book for the upcoming June 23 noted improvement in all 12 districts, but sounded a sober note by saying growth in many was “modest.”  Beige book also noted that the labor market “improved slightly” in most districts, but that wage pressures remained “minimal.”  Also, contacts in some districts were worried about fallout from the European crisis, something that was echoed in testimony by Fed Chairman Bernanke.  He said the Fed is “highly attentive” to risks from Europe, and that restarting the emergency dollar swap lines sends an important signal that the Fed will act to ensure stability and recovery.  While calling for long-term fiscal sustainability, he added that now was not the time to radically cut spending or raise taxes.  He also noted that higher US interest rates would complicate efforts to balance the budget.  Of course, the Fed has no say on US fiscal policy, but markets are certainly taking note of Bernanke’s dovish stance with regards to fiscal policy which in turn suggests that he is maintaining his dovish stance on monetary policy as well.  federal funds futures rallied on the day, with no significant odds of tightening being priced in before Q1 11 now.  UST market also rallied on Bernanke comments, reversing early losses. 

Newswire is reporting that Russia remains committed to diversifying its reserves and has not changed its view of the euro.  This is consistent with what several other central banks, including China, Japan, and Korea have indicated recently.  That said, Russian data out in the middle of last month showed an increase in dollar holdings (44.5% vs. 41.5% at the end of 2009) and a decrease in euro holdings (43.8% from 47.5%)  However, valuation shifts likely account for the bulk of the change.  In the first four months of the year the euro was the worst performing among the G10 currencies, falling about 7.2%.  And two other currencies that Russia may hold in reserves, the Australian and Canadian dollars were the strongest in the first third of the year, appreciating about 3% and 3.5% respectively.  We have been bemused with prior reports and commentary that have emphasized the pro-cyclical nature of central bank reserve adjustments.  Talk of shift out of dollars seemed to reach a crescendo when the dollar is falling and weak.  And now that the euro is weak, there is speculation that central banks will reduce their euro holdings.  To the contrary, assuming that one expects EMU to survive the next several years, the longer-term project of diversifying reserves, or allocation adjustments, are more likely to be counter-cyclical.  That is, long-term participants should be expected to buy on weakness and sell into strength.  The euro’s role as a reserve currency ultimately may not be adversely impacted by the crisis provided confidence remains that it actually survives this challenge.

Bank of Korea meets Thursday and is expected to keep rates steady at 2%. Indeed, we feel strongly that the current crisis in Europe is likely to keep most central banks in a wait-and-see mode for the next several months.  Market is looking for rate hikes to start in Q3, but we feel this could be pushed out until Q4.  Headline CPI rose 2.7% y/y in May vs. 2.6% y/y in April, but core CPI rose only 1.6% y/y vs. 1.5% y/y in April, which was the low for the cycle.  Mortgage lending has slowed to 7.9% y/y in May from 11-12% growth in late 2009, while overall loan growth slowed sharply to 3.3% y/y in March and April before rising slightly to 3.7% y/y in May.  Still, the real sector remains in good shape, and so policy decisions will be tough in the coming months.  Unemployment eased to 3.2% (both unadjusted and adjusted), the lowest since late 2008, while Q1 GDP growth was revised up slightly to 8.1% y/y from 7.8% y/y previously.  Exports and IP are both growing robustly.  The one thing that is unpredictable is the situation with North Korea, but economic fundamentals remains strong.  We remain concerned about developments in Europe, and believe that EM FX remains vulnerable to another bout of selling after the current period of calm ends.  Korean won is the worst performer in Asia so far in Q2, down 9.4% vs. USD.  The won’s underperformance is due in large part to heightened tensions with the North, but overall nervousness regarding EM has taken a toll too.  Won bulls will be disappointed by the fact that it has not taken part in recent EM FX gains and in fact is the only EM currency to have lost ground against the dollar so far this week.  Given this recent price action, we think USD/KRW is likely to test the May high of 1278 and then the 38% retracement level of the 2009-2010 drop at 1292.  However, we do not think policy-makers are unhappy with KRW softness as long as the pace is under control. 

Hungarian forint is stabilizing, but rally running out of steam around 280 vs. the euro. While panic has subsided, we think market is rightfully skeptical of Hungary’s plan to cut public sector jobs and spending while also cutting personal and small business income tax in order to meet the 3.8% of GDP deficit target this year.  Fitch was correct to say that the plan lacks details on “costing, timing, and credibility” and so seemed to signal a wait and see approach on its BBB rating.  The fact that the government is now pledging to meet the deficit target after earlier warning of an actual number around 7-8% should be positive, but the about-face will undoubtedly raise eyebrows.  That tells us that Hungary still needs IMF/EU aid and was basically told that slippage was unacceptable.  We also do not think that the IMF will sign off on these proposed tax cuts, as they are simply not part of the IMF playbook.  Fidesz party was elected on promises of tax cuts and other stimulus measures, but we think market realities will ultimately derail those pledges and hurt its popularity.  Still, the change in tone of official comments is enough to stabilize the forint, but we do not think further gains are likely until fiscal uncertainty has cleared up.  For EUR/HUF, 280 is a key level representing the 62% retracement of the June swoon.  Break would target the June low around 274.  But given our continued pessimism on Western Europe, we would look to play HUF from the short side after the current rally runs out of steam.  We look for a return to the June high around 290, as Hungary fundamentals are amongst worst in EMEA.

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