Euro Weakens As More Stress Test Leaks Are Disappointing

From the BBH Currency Strategy Team

Highlights

US dollar is softer on the day vs. the majors, gaining only against EUR and SEK as markets search for direction ahead of Friday’s stress test results.  The euro is trading softly after making a marginal new high for the cycle vs. the dollar at 1.3029 Monday, and break of the 1.27 area would signal a move back to the July 13 low around 1.25.  Euro is perhaps being pressured by less favorable leaks of bank stress tests (see below), which are feeding into market concerns that the tests will not be as rigorous as hoped for.  The yen was firmer across the board, suggesting risk aversion is back in play today, while the Swiss franc was mostly firmer.  EM FX was mostly softer, with Eastern European currencies faring poorly today.  Biggest gainers on the day so far vs. USD are JPY, CAD, ZAR, INR, and NOK, while biggest losers vs. USD so far are CZK, EUR, PLN, RON, and HUF.  China concerns continue, leading markets to pare back CNY appreciation views to the lowest since early June, while Brazil expected to hike 75 bp today (see below). 

Asian markets were mostly higher, as MSCI Asia rose almost 1% today.  HK outperformed, while Japan, Taiwan, and Singapore underperformed and were down on the day.  European markets are higher so far today, with Euro Stoxx 50 up over 1%.  Futures markets are currently pointing to a flat open for US equity markets today.     

US bond market is likely to continue benefiting from safe haven flows as well as concerns about weak US growth.  Japan bond market was flat, while European bond markets are mostly lower as 10-year yields in UK, France, and Germany are down 2 bp, up 1 bp, and up 1 bp, respectively.  Greek 10-year yields are up 4 bp, Portugal flat, Ireland flat, Italy up 1 bp, and Spain down 1 bp.  Portuguese auction went poorly today after heavy peripheral supply yesterday was absorbed easily.   

Currency Markets

The European bank stress test leaks continue, and feed into concerns about their robustness.  According to a leaked document, the tests will describe three scenarios:  one under benchmark assumptions, one with an adverse scenario, and one that includes a “sovereign shock.”  Clearly, this will be the scenario that garners the most attention by the markets.  Despite the relative calm seen in the periphery this past month, CDS prices and bond spreads are still pricing in significant default risk in Greece and others in the periphery.  What sort of recovery rate will the sovereign shock scenario assume?  Back in early July, some reports suggested that the stress tests included an assumed 17% loss on Greek bonds.  Adding to the confusion, the FT reported today that a Greek haircut of 23% was being assumed.  Bankers were quoted by the FT as saying the impact of those haircuts was likely to be inconsequential because they would be applied only to bonds held in banks’ trading books.  Banking analysts believe that most Greek sovereign debt is now being held not in trading books but in banking books, where they are designed to be held to maturity.  Accounting rules allow banks to shift holdings between these two books, and so the picture could get quite muddied and could be another potential flashpoint for the markets on Friday.  Putting which books are affected aside for now (which is a big problem in itself), haircuts of either 17% or 23% both seem too modest.  Greece pays 775 bp more than Germany on 10-year bonds, and back of the envelope calculations suggest a much greater haircut being priced.  Germany and Portugal bond auctions went poorly today.  This may have been due to some market fatigue after yesterday’s heavy issuance schedule by Greece, Spain, and Ireland, but it may also reflect some adjustment in market expectations regarding the stress test results.  Also, it was reported that Portuguese banks borrowing from the ECB jumped 12% in June to EUR40.2 bln, much like what Spanish banks have done.  Meanwhile, the Swiss National Bank revealed losses of over CHF14 bln in H1 from its massive foreign exchange operations to prevent excessive CHF weakness.  It has stopped intervening due to what it sees as diminished deflationary risks, but we suspect concerns about FX losses may have played a part in the decision after these numbers were released.  The only good news was that SNB holdings of gold and other assets jumped, so that overall losses in H1 were limited to CHF4 bln.

BOE minutes for July read as expected.  Vote was 7-1 in favor of keeping rates steady, with Sentence dissenting once again in favor of higher rates.  He favored a 25 bp hike to 0.75% as inflation risks had “shifted sufficiently to justify beginning to raise interest rates gradually.” Other BOE members noted that the economic outlook had “deteriorated  a little” and justified keeping rates steady, as spare capacity was seen bringing inflation back down to the target over the medium-term once the impact of temporary factors wore off.  MPC also noted that while the impact of fiscal policy was hard to gauge, tightening ad most likely pushed down the growth trajectory.  MPC noted that the near-term inflation prospects had worsened, and that VAT hike would add to inflation in 2011.  BOE is caught between a rock and a hard place, as inflation has run above target while the recovery remains vulnerable to early tightening.  At least the Fed, BOJ, and the ECB have the luxury of low inflation numbers that can allow rates to be kept low for the foreseeable future.       

Given rising concerns about China growth, 12-month NDFs are now pricing in only 1.1% appreciation, and is the lowest since early June BEFORE the depegging of the yuan.  As we noted yesterday, there are a lot of things that worry us right now, but China isn’t even in the top three.  We think that the current sell off in the CNY NDFs will offer investors a chance to establish long CNY positions.  12-month forwards appear too cheap and we believe market is underestimating appreciation potential.  Even if growth moderates to a more sustainable 10% in China, we don’t think that will prevent modest appreciation of 3-5% over the next 12 months.  Brazil central bank decision today has been clouded a bit by recent inflation data. Mid-July IPCA just came out, and fell unexpectedly m/m which led to further easing in the y/y rate to 4.7% from 4.8% in June and 5.1% in mid-June.  Interest rate futures have adjusted accordingly, with markets now pricing in a 50 bp hike.  However, analysts expect the central bank to hike rates by 75 bp to 11%.  We also note that analysts are now looking for a year-end policy rate of 12%, down from 12.13% earlier this month but up from 11.75% last month.  Economic data remain strong even though price pressures eased slightly this past month, and so the case for sizeable tightening is still present and we think a 75 bp hike will be seen tomorrow.  USD/BRL saw resistance around 1.80 Monday and is moving back to test the downside of the 1.75-1.82 trading range that’s been in place since early June.  For now, that 1.75 floor seems to be a strong obstacle for the real, so the potential for appreciation is limited.  On the other hand, high yields and limited BRL downside are proving to be quite attractive for investors.

Upcoming Economic Releases

Canada wholesale sales for May due out 8:30 EST/12:30 GMT and are expected to rise 0.4% m/m after dropping 0.3% m/m previously.  Mexico retail sales for May due out 10:00 EST/14:00 GMT and are expected to rise 3.4% y/y after dropping 0.1% y/y previously.  Brazil central bank decision due today but no time specified, with markets looking for 75 bp hike to 11.0%.  Fed’s Bernanke testifies before Senate Banking Panel at 14:00 EST/18:00 GMT.