Stresses Remain In Play For Europe

From Win Thin, Senior Currency Strategist at BBH.

Bloomberg headline reads “Europe’s Budget Cuts Pose Risk to Debt Ratings, Moody’s Says.”  Really?The article goes on to quote the agency as saying budget cuts in response to the European crisis will weigh on growth and thus increase the risks of rating downgrades.  What would Moody’s have said if these countries HADN’T tightened fiscal policy?  Remarks were contained in Moody’s semi-annual European Sovereign Outlook that was just published today, and it is comments like this that have seen ratings agency credibility head south during this entire financial crisis.  In other words, Europe faces downgrade pressures no matter what the policy-makers do.  Agencies appear to be flailing right now.  Our view has always been that the fiscal tightening measures done within a context of recession were always doomed to failure, but Moody’s is being disingenuous by playing both sides of the argument.

Despite all the optimism that was originally generated by the European bank stress tests, we note that peripheral spreads to Germany have continued to widen out.  While core spreads have for the most part held steady since the July 23 stress test results, ongoing pressures in the periphery suggests that markets remain very concerned about Europe in general.  This is also supported by data showing that peripheral banks continue to be big takers of ECB liquidity.  These are all negative factor weighing on EUR, and should continue doing so in the coming weeks.  As we noted before, when the global backdrop was more supportive, markets could overlook the warts on the euro zone periphery, but now that risk appetite is drying up within the context of slower global growth, those flaws look extremely worrisome.  Next big level for EUR seen at 1.26 but for now, the single currency is finding modest support around 1.27.

We also think these stresses in Europe are a big factor behind the ongoing strength in CHF.  For now, SNB seems to be signaling little willingness to intervene.  SNB President Hildebrand said over the weekend that “We’d reach our limits at the point where a possible additional expansionary monetary policy would spark inflation over the longer term.”  However, he added that the central bank would still be able intervene if needed.  EUR/CHF bounced after making new lows for this move and gives investors an opportunity to go long CHF at better levels.  We think EUR/CHF is still on track to continue probing the downside and testing the July 1 low around 1.3070.  Given the safe haven flows being seen by rising risk aversion, we don’t think there’s much that the SNB can do to counter the safe haven demand into the franc and so new lows in EUR/CHF are likely in the cards.