Risk On Trading Picks Up Ahead Of Case-Shiller Report

From the BBH Currency Strategy Team

Highlights

US dollar is softer vs. the majors, as sentiment remains positive and risk on trading picks up.  Dollar is up only against JPY and CHF, which are both weaker today and finally succumbing to improved environment after firming on Monday.  The euro is trying to move through 1.30, helped by German GfK consumer confidence for August at 3.9 vs. 3.5 expected and revised 3.6 (was 3.5) in July.  EM FX is firmer across the board, as fundamentals remain very strong and more central banks are hiking rates (Israel Monday and India today, see below).  Even Hungary is recovering along with the rest of EM, with a decent 3-month T-bill auction that saw good demand but at still-elevated rates.  Biggest gainers on the day so far vs. USD are HUF, KRW, INR, PLN, and ZAR, while the only losers vs. USD so far today are CHF and JPY.

Asian markets were higher on carry over from US rally Friday, and MSCI Asia was up 0.6% today.  Thailand, Pakistan, and Sri Lanka markets outperformed today, while China, Taiwan, and New Zealand underperformed and fell on the day.  European markets are higher today, with Euro Stoxx 50 up 1.1% so far.  Futures markets are currently pointing to a flat open for US equity markets today.     

US bond market is weaker as global risk sentiment improves, but should be underpinned by the weak US growth outlook.  Japan bond market was higher as 10-year yields were down 1 bp today, while European bond markets are mostly higher as 10-year yields in UK, France, and Germany are up 2 bp, down 1 bp, and flat, respectively.  Greek 10-year yields are down 12 bp, Portugal down 18 bp, Ireland down 12, Italy down 5 bp, and Spain down 11 bp.   

Currency Markets

We continue to watch for clues in the days ahead that the tests have eased stresses in the European banking sector. Our gut feeling is that they have not yet, especially if one looks at interbank lending rates.  EURIBOR rates have been rising steadily since April, due in large part to perceived jump in counterparty risk.  As a result, weaker banks from the periphery have been big users of cheap ECB funding as an alternative.  Note that 3-month EURIBOR continues to creep higher and was fixed today at its highest level (.8275%) since the summer of 2009.  ECB reported that it bought only EUR176 mln of sovereign bonds last week, the lowest since the program began in May.  Sovereign spreads are tightening today on improved sentiment, but remain quite elevated and are still pricing in significant default risk for Greece.  But overall, despite the continued creep upward in EURIBOR, FX markets are relieved that stress tests, however flawed, have finally been released.  The 1.30 level is very important, representing the final 62% retracement level of the big April-June sell off in the euro.  Clear break would target the post-ESFS high around 1.31 and then ultimately the April 12 high around 1.37.  

India central bank hiked the reverse repo rate by 50 bp to 4.5%, more than the expected 25 bp.  Inflation has stabilized, but remains at very elevated levels even though RBI officials are sounding a bit more optimistic on the inflation front than we are.  In May, industrial CPI rose 13.9% y/y while rural CPI rose 13.7% y/y.  On the wholesale side, WPI rose 10.6% y/y in June and is still accelerating.  The government hiked gas and diesel prices in June, so look for all the inflation measures to move higher in the coming releases.  GDP growth is surging, up 8.6% y/y in Q1 vs. 6.5% y/y in Q4, and so further tightening is warranted.  Despite the prospects of strong growth and higher interest rates, INR is the worst Asian EM currency in Q3 so far and the only one that’s down vs. USD.  We remain nervous about the global backdrop, and so INR underperformance is seen continuing.  High inflation is one of the factors behind INR underperformance, and so the RBI needs to get ahead of the curve.  Intra-meeting move this month and then the bigger than expected hike today is a good start, but we wouldn’t rule out another intrameeting move towards the end of summer or the beginning of autumn. 

On the other hand, Turkey is sounding quite dovish.  In its quarterly inflation report, the central bank cut its year-end inflation forecast to 7.5% and signaled that it may keep rates steady until 2011.  Forecast was 8.4% back in April, but Governor Durmus Yilmaz said forecasts are based on the assumption “that policy rates are kept at current levels and that there is a limited rise in 2011.”  He stressed that conditions have become more supportive for lower inflation since the last report in April, when the bank predicted rate increases starting in Q4 10.  Next policy meeting is August 19, and clearly rates will be kept steady then.  The bank’s dovish outlook this year has been justified so far by steadily lower inflation after a spike up above 10% early this year.  We had penciled in a Q4 start to the tightening cycle, but it’s clear that the central bank will delay rates as long as possible.  Still, current policy rate of 7% remains very supportive of the lira, especially in the current risk on environment.  Charts point to a test of the April low around 1.4680. 

Speaking of dovish, we still think South Africa rate cuts remain on the table.  Today, unemployment was reported ticking up to 25.3% in Q2 from 25.2% in Q1, and with the recovery lagging, we expect policy-makers to get serious about further stimulus.  Even the successful World Cup did little to help the labor market, even temporarily.  Given the amount of time spent discussing the rand recently by officials, the strong currency is clearly causing some worries.  Market is on track to test the April low around 7.2, but we think the odds of some sort of mild capital controls rises significantly as we approach 7 in USD/ZAR.  

The RBNZ is holding its regular policy meeting late today and a further 25bp rate rise (only the second one in the cycle) is widely expected.  This would take the cash rate to 3%.  This week’s meeting comes amidst mixed economic news even as underlying price pressures are gradually picking up.  Q2 headline CPI rate ran at just 1.8% y/y (from 2%), but underlying inflation which is more relevant from a monetary policy direction perspective is picking up and the Bank is forecasting inflation to peak at 5.3% next year – most analysts see this as a conservative forecast.  July 1-year inflation expectation has picked up to 5% from 3.4%. The price outlook should provide enough ground for the central bank to deliver a further rate rise this week, but the economic case for more rate hikes is not all that convincing and a pause in the tightening cycle initiated last month may be seen before the end of the year.  All this means that notwithstanding the recent pause in the RBA’s tightening cycle, the yield advantage will continue to favor Aussie bulls over kiwi bulls.  AUDNZD has been fairly stable within a 1.2100-1.2350 trading range over the past couple of weeks. Aussie bulls should not worry too much ahead of this week’s RBNZ meeting: a rate rise seems most likely, but the case for higher rates is not all that compelling in New Zealand at this point and the central bank may opt to pause its tightening cycle within the next few months. Meanwhile, rate hike talks could resurface for RBA as early as next week.

Upcoming Economic Releases

US CaseShiller home price data for May due out 9:00 EST/13:00 GMT and expected to rise 0.2% m/m vs. 0.4% m/m in April.  At 10:00 EST/14:00 GMT, Richmond Fed manufacturing index for July due out and expected at 12 vs. 23 in June.  At the same time, Conference Board consumer confidence for July due out and expected at 51 vs. 52.9 in June.  US Tsy’s Brainard testifies on climate change at 14:00 EST/18:00 GMT.