Ireland’s Uncertainty Continues to Weigh on Euro

Highlights
The US dollar is little changed as markets start to muse the impact of a possible bailout of Ireland but remain cautious over China’s intended tightening, which continues to weigh on commodities and overall risk appetite.  The euro continues to weaken versus the greenback, sliding down to $1.34 area despite the high probability of a resolution over Ireland.  Cable edged higher following better-than-expected employment data but soon retreated back to the $1.58 area with the MPC minutes providing little change to the price action.  The dollar continues to edge higher against the yen and elsewhere the Australian dollar gave back most of its early gains as risk appetite pares back. 

Global equity markets are mostly mixed with losses in emerging markets and Asia as China continues to announce steps to tame inflation.  The MSCI Asia index is down 0.7% with stocks weaker in China yet positive gains in Japan.  The 0.1% gain in the Nikkei is led by a 0.6% gain in consumer goods but a 1% loss in energy.  The Shanghai is down nearly 2% led by a 6.5% loss in health care.  In Europe, the equity recovery is led by a 0.5% gain in the Dax as consumers services and financials outperform .  At the same time the FTSE is flat led by a 2% loss in telecommunications.  Overall, the Euro Stoxx 600 is up by 0.4%.  Other features in North America is the GM IPO, which has increased in size and orders, leading to oversubscribed demand from foreigners and marginal demand for the US dollar.

European sovereign bonds yields have started to moderate as a rescue package for Ireland’s banks appears to be in the works.  Additionally, LCH Clearnet raised it margin requirement for Irish bonds to 30% from 15%.  Irish 10-year yields are up 3bp yet Portuguese yields are up 4bp on the day following a weak bond auction.   Portugal sold €750mln of 12 month bills, in line with the indicative amount, but the bid to cover ratio still fell to 1.8 from 2.2 in the previous sale.  Yields increased to 4.813% from 3.26% in the previous 12 months.  The sharp rise in borrowing costs highlights the impact Irish concerns has on yields in other eurozone peripherals and if Ireland gets an aid package, markets are likely to sooner or later push for a deal on Portugal.  Meanwhile, German 10-year yields are down 2bp with US Treasuries up 2bp. 

Currency Markets

The Irish situation remains unresolved.  Yesterday’s euro zone finance ministers meeting have been broadened today to include EU finance ministers.  This is important because the UK clearly has a vested interested in Irish developments in a way that it didn’t for Greece.  Two partly owned UK banks have among the largest exposures to Irish firms and households.  The Bank of Ireland runs Britain’s Post Office savings arms.  UK exposure is estimated at about GBP145 bln.  And this is to say nothing about the extensive trade ties.  The key difference between the Irish situation and the Greek situation is the crux of the former’s problem lies in the private sector.  The government, as widely acknowledged, has sufficient cash on hand to avoid having to go to the capital markets for several months.  The banks however remain at risk.  Their ability to raise capital has been limited largely to short-term funding and with options to put the  note back to the bank at face value. As these are put back to the bank, it compounds their funding needs.   Irish banks are also extremely dependent on the central bank financing.  They account for around 25% of the ECB’s liquidity.  Additionally, the exceptional liquidity provided by the Irish central bank has risen substantially over the past week.  The problem as we have noted is the Irish banking system is too big for the government to rescue.  Rescue as opposed to receivership is the ideologically preferred course.  One of the most important issues for traders and investors is whether some sort of package for Ireland would arrest the crisis.  We are less sanguine and are concerned that pressure will mount on Portugal and increasingly Spain.

US inflation preview: The 0.1% U.S. CPI headline gain in September, with a flat core figure, reflected a similar mix of food and energy price gains as seen with yesterday’s PPI report for the month.  Both reports captured only some the commodity price firmness evident in Wednesday’s September trade price report, which extended the August resumption of the year-long price up-trend for globally traded goods.  More rapid commodity price gains in October will extend the recent price bounce.  Furthermore, given the Fed’s focus to adhere to its dual mandate of price stability and economic growth one of the goals of QEII will be to stoke inflation expectations.  In the run-up to the QEII announcement the Fed was able to drive investors into stocks by lowering the real yield of fixed income investments.  They accomplished this by raising inflation expectations (5y5y forward) while anchoring short-term bond yields, thereby driving the 5-year real yield to nearly -2%.  The rapid rise in the real yield may help explain much of the dollar strength since the announcement and much of the weakness as it dropped.  Yet the main concern is still deflation and although there has been a slight uptick in the 2-5 year breakevens and UoM inflation surveys, the economy is still nearly 6.5% from its potential, according to CBO estimates.  Therefore, any pass-through from commodities is likely to be muted as core inflation remains well below the Fed’s comfort level but the outlook for QEII remains highly contingent on data.   

U.K. September earnings growth including bonuses rose to 2.0% 3m y/y, versus 1.7% in August and in line with consensus. Meanwhile, excluding bonuses, earnings rose to 2.2% in the three months to September, the highest since March 2009 and versus 2.0% in August. Though September data point to an uptick in earnings growth, real wage growth is still weak and we see little inflationary threat from pay growth.  Wage growth is another concern outside of the regular consumer baskets that will be considered when debating further QE.  With the 5y5y forward breakeven still above the BoE ceiling of 3% continued moderation of wage growth may keep the door open for further QE.

Upcoming Economic Releases

At 08:30 EST / 12:30 GMT the US reports October’s CPI.  The headline m/m is expected to increase to 0.3% from 0.1% in September.  The m/m core inflation is expected to increase to 0.1% from 0.0% in September.  At the same time September’s housing starts are expected to decrease to 598k from 610k in September, a 2% m/m decline.   Building permits are expected to increase m/m to 3.9%.  Events: Fed’s Bullard (FOMC voter) to speak at 9:15 EST / 13:15 GMT.