Dollar Mixed on Irish Bailout Concerns

Highlights
The US dollar is on a more solid footing yet continues to consolidate versus the euro as details emerge of a potential Irish bailout.  The uncorroborated rumors of a bailout of Ireland emerged from the G20, narrowing the yields on the periphery, allowing the euro to firm but failing to reach yesterday’s close.  Any further doubts over the Irish bailout should drive the euro to test the mid $1.36 range with further lows leading to another two cent decline.  Sterling continues to consolidate reaching a new two-day low of $1.5985.  Meanwhile as risk appetite wanes the higher-yielding, growth-sensitive currencies in the G10 continue to suffer.  The Australian dollar, Canadian dollar and New Zealand dollar all continued to underperform with Aussie dollar retreating from parity.

Asian stocks dropped back with Chinese stocks suffering sharp declines amid speculation of further tightening from the People’s Bank of China. The Shanghai composite tumbled 5.1% led by a 6.8% loss in tech stocks.   The Nikkei was down 1.3%, as well, with tech and industrials down 2.3% and 2%.  On the whole the MSCI Asia Pacific index dropped 1.4%, and is set to end the week lower for the third time in four weeks.  Meanwhile, risk appetite continued to wane in Europe with most major indices down.  For one, the Euro Stoxx 600 was down 0.6% led by a 1% loss in materials, although utilities and financials were up 0.5%.  Germans stocks continued to retreat with the Dax down 0.1% led by losses in telecommunications while the FTSE was flat with basic materials down 1.6% and utilities up 1.2%.

Eurozone spreads continue to fluctuate on speculation that the European Finance Ministers are working on a bailout package for Ireland in an attempt to reassure investors.  The rumors have not been corroborated yet the periphery yields continue to narrow.  10-year Irish yield, for example, are down nearly 66bp on the back of the news with the Portuguese 10-year down 25bp.  10-year Greek yields are down 9bp with Spanish yields up marginally by 1bp.  Meanwhile, German 10-year yields are up 5bp with the 2-year US Treasury up 4bp followed by the 10-year with a 3bp increase. 

Currency Markets

G20 said that it was appropriate for countries to adopt capital controls to cope with potentially destabilizing inflows.  However, as we expected, no sort of coordinated plan was in the making. Indeed, this simply maintains the status quo of countries taking unilateral actions to manage inflows.  We do not expect any comprehensive multilateral solution for the capital inflow problem, simply because we do not think one really exists.  Given recent developments in Europe, it appears that the G20 countries spent more time discussing Ireland than they did on global imbalances and currency stability.  However, we do not think that the G20 holds the key to solving Europe’s woes.  That will have to come from the EU, and so far, policy-makers remain reactive as events spiral out of control.  Markets should not be spooked by talk of private-sector burden sharing.  That is the only possible way out for the highly indebted periphery, and as we have written countless times, the sooner it’s done, the better.  Otherwise, much of the euro zone faces a Latin American-style Lost Decade.

In addition, Leaders from Germany, France and the UK sought to reassure investors in the solvency of countries such as Ireland with the proposed sovereign debt mechanism (SDRM).  The Finance Ministers issued terms of reference for the proposed SDRM at today’s G20 summit. The terms of reference state that "whatever the debate within the euro area about the future permanent crisis resolution mechanism, and the potential for private-sector involvement in that mechanism, we are clear that this does not apply to any outstanding debt and any program under current instruments. Any new mechanism would only come into effect after mid-2013 with no impact whatsoever on the current arrangements".  This is the preliminary details with more announcements expected later in the day. But overall Ireland has enough cash to avoid going to the market until mid 2011 and it appears unlikely that the political leaders of these nations will make an early decision unless forced to.  For sure, the fiscal situations in countries like Ireland and Greece are unsustainable and indeed the budget issues will only worsen as their economies shrink.  But the most likely scenario is that restructuring takes places in 2013 or 2014 with the more pressing issue is the possibility that Ireland borrows directly from the EFSF in early 2011.  Back of the envelope calculations suggest that the real borrowing costs of the EFSF facility are around 8% which may be a bit too expensive for Ireland to bear as GDP would continue to contract and more tax revenues would be spent paying down the debt.

Eurozone Q3 GDP growth slowed to 0.4% q/q suggesting that the eurozone pace of growth is moderating. The slowdown is a tad behind the market consensus and nearly half the pace of last quarter’s 1%. There is no breakdown with the preliminary number, but French data and indications from the German statistical office suggest that domestic demand is stabilizing, and the recovery is broadening, which is good news for trends ahead. However, growth remains very uneven across countries, with peripherals lagging core eurozone countries, especially Germany, which is making the ECB’s job quite difficult. Fundamental to the sovereign debt yield blowouts and euro frailty we’ve been seeing  is the concern that European growth has peaked, particularly in the engine of the economy Germany, and the outlook is looking bleak with the array of austerity measures due to be implemented.  Since EUR/USD reached a 10-month high last week, peaking at $1.4282, the return of concerns over the fiscal situation of European periphery countries has led to a consistent and pretty sharp decline of more than six big figures to flirt with a break down through $1.36. This fits into our view that the euro is currently in the process of carving out a top for this cycle against the dollar, and that problems in the periphery are coming back to the forefront of market consciousness to weigh once again on the euro.  We expect if the euro could reach our next target level of $1.3650 that a retracement back to the $1.3450 level is likely to be tested. 

Upcoming Economic Releases

At 09:55 EST / 13:55 GMT the US reports the University of Michigan confidence index.  The consensus if for a small uptick to 69.0 from an October reading of 67.7.  There are no Fed speakers or central bank events today.