Euro Hurt as Risk Aversion Picks Up

Highlights
The US dollar is firmer across the board vs. the majors as risk aversion carries over today.  Euro is coming under pressure and making new lows vs. the dollar after peaking on August 6 and has now broken the minimal retracement target of the single currency’s June-August rally around 1.2780.  We now target the 50% level around 1.26, but it is finding modest support around 1.27.  ECB comments and Greece news may have provided an excuse to sell the euro (see below), but the currency had been trading heavy all week.  The yen and Swiss franc are mostly firmer today as well, while EM currencies are softer.  There are no gainers vs. USD so far today, while biggest losers are NOK, PLN, HUF, SEK, and ZAR.  No US data out today, but recent technical damage points to further EUR losses.  AUD is being hit ahead of this weekend’s election, but this is due in large part to the risk off trading being seen (see below for election preview).             

Asian equities were mostly lower, with the MSCI Asia-Pacific Index posting a 1.4% drop in the aftermath of yesterday’s market sell off.  Philippines, Indonesia, and Thailand outperformed and were higher on the day, while China and Japan underperformed as the Nikkei 225 posted a 2% drop to erase the previous two days of gains.  European bourses are trading lower so far today.  US shares are likely to come under more pressure as futures trading points to down opens for the major US indices. 

Core bond markets are firmer today on the rise in risk aversion, with markets perhaps realizing that recent optimism on the periphery may have been overdone.  The Greek-German spread has widened 4 bp to +828 bp on news that Greece was asked to make further spending cuts despite meeting the conditions needed to receive its second aid tranche (see below).  Spain, Portugal, Ireland, and Italy spreads are wider by 5-7 bp so far today.  US Treasuries have regained some ground on the flight to quality trade, with 10- and 30-year yields 4-5 bp higher on the day. 

Currency Markets
The euro has broken down during early European trading after holding steady in the Asian session.  ECB comments may have provided an excuse to sell the single currency, but it really looks like the euro is suffering from recent and continued failures to break above 1.29.  Some attribute the euro weakness to comments from ECB’s Weber that liquidity and stimulus measures should be kept in place until after year-end.  To us, those comments should come as no real surprise as year-end funding pressures could be destabilizing and so the ECB appears willing to continue providing liquidity for the system.     Weber said it would be “wise” to keep full allotment in weekly, monthly and three-month refi operations until after year-end, while Trichet has only guaranteed unlimited 7-day loans until Oct 12 and 3-month money until the end of September.  Weber added that there no inflation risks in sight, so the dovish talk is noteworthy coming from the likely successor to current ECB chief Trichet, though his term does not end until Oct 2011 and so Weber’s stance is not yet key.  Markets may also have been spooked by reports that the European Commission asked Greece to cut government spending by an extra EUR4 bln this year to ensure that it cut its deficit to 8% of GDP.  It noted that “The fiscal measures adopted by Greece so far appear sufficient to reach the 2010 budgetary deficit ceiling targets … provided that expenditure control remains very tight, leading to total state expenditure of EUR4 bln below plans, to offset revenue shortfall and expenditure slippages in other government sectors.”  No wonder peripheral bonds are softer today.  The yen is softer today vs. the buck as the latter outperforms and so is off the radar screen for now as pressures in Europe pick up.  However, the Swiss franc is firmer across the board today and so EUR/CHF is making new lows for this move and is on track to continue probing the downside and targeting the July 1 low around 1.3070.  Given the safe haven flows being seen by rising risk aversion, we question whether the SNB would dare intervening now.  If market sentiment is really heading south, then there’s not much the SNB can do to counter the safe haven demand into the franc.

Australian dollar is trading softer ahead of the weekend elections, but we think weakness is due more to overall risk off trading than politics.  Indeed, AUD continues to outperform NZD despite the elections, and looks likely to continue its march higher.  Most recent polls show a very tight race between ruling Labor and opposition Liberal-National coalition, and it appears that the issue of the mining tax is still having reverberations.  The race is so tight that UK press is running a story that absentee ballots from the up to 200,000 expats in London could prove to be decisive.  Gillard had enjoyed a slim lead early in the campaign, but has seen her support erode such that she risks being at the helm of the first single-term government since 1931.  While Prime Minister Gillard has signaled some willingness to modify former PM Rudd’s proposal, the matter continues to weigh on Labor’s popularity.  Hung parliament is certainly possible for the 150-seat as some polls suggest the Greens could pick up enough support to play king-maker.  Given the Greens’ support for the resource tax, a Labor-Green coalition would be seen as negative for the markets.  Liberal’s Abbott has pledged to rescind the controversial tax if elected, and polls suggest that the tax issues has boosted his standing in the Western resource states at Gillard’s expense.  Liberal victory is the bullish outcome for Australian markets.  RBA Deputy Governor Battellino sounded hawkish, saying inflation has always been a problem for Australia during commodity booms.  He added that the RBA sees core (trimmed mean) inflation staying steady for the next year or so, but upward price pressures after that.  Market currently sees no more RBA tightening over the next 12 months, so his comments warrant some caution regarding monetary policy expectations.  AUD vs. USD will be tricky to trade given the recent swings in sentiment, but we remain confident that our long AUD/short NZD trade recommendation remains in play.

Canadian dollar is under pressure, with euphoria from recent M&A announcement giving way to selling pressures due to increased concerns about the US economy. July CPI was softer than expected, as headline came in at 1.8% y/y vs. 1.9% y/y expected.  More importantly, core CPI fell m/m unexepctedly and dragged the y/y rate lower to 1.6% from 1.7% in June, the lowest rate since Dec.  BOC next meets September 8 and we believe the weak US data and now easing price pressures will give it leeway to stand pat then.  BOChas now hiked 25 bp twice (in June and July) to take the policy rate to 0.75%.  Markets have pared back tightening expectations as US outlook deteriorated, with only 50 bp of hikes expected over the next 12 months.  USD/CAD spiked higher on the data report, and is on trace to test the mid-July high around 1.06.  After that is June/early July high around 1.07 and then May high around 1.0850.

Upcoming Economic Releases
No US data releases scheduled today. Brazil reports mid-August IPCA inflation at 8:00 EST/12:00 GMT, and is expected to rise 0.1% m/m vs. -0.1% m/m previously.  Poland reports July core CPI at the same time and is expected to rise 0.1% m/m vs. 0.2% m/m in June.  At 10:00 EST/14:00 GMT, Mexico reports Q2 GDP that is expected to grow 7.5% y/y vs. 4.3% y/y in Q1, and at the same time Banco de Mexico will announce its policy decision.  Rates are expected to be kept steady at 4.5%.  Colombia central bank policy decision due out today but no time given.  Fed’s Bullard speaks at 13:00 EST/17:00 GMT on the US economy.