Tensions in Libya Batter Risk Appetite

From the BBH Currency Strategy Team

Highlights
The US dollar is broadly stronger this morning as geopolitical tensions in Libya and the Middle East prompt demand for safe haven securities. Indeed, the dollar, yen and Swiss franc are all higher as the reboot of risk-off has driven a large position squeeze as investors leveraged for growth in higher-yielding currencies flock to the greenback. The euro retraced some early session losses on the back of hawkish ECB rhetoric yet is likely to meet resistance ahead of $1.3685. Sterling, meanwhile, remains on the defensive after the pickup in risk aversion hampered buying momentum, with the tensions in the Libya likely to keep the dollar bid. The dollar slipped under the ¥83.00 area as safe haven offset Moody’s debt concerns. The New Zealand dollar fell to a two-month low, dropping nearly 2% to $0.745, after an earthquake in Christchurch altered the outlook for monetary policy, while CAD is likely to benefit from positive retail sales.

Global equity markets are broadly lower as the turmoil in the Libya dampens risk appetite. Asian stocks declined for a second straight day, with the MSCI Asia Pacific index down 1.8%, while the Nikkei declined 1.7% (after it closed Monday at a near 10-month high), as investors worried about the negative terms of trade effect on Japan as energy prices surge. The Kospi in South Korea was also battered, down 1.8, as construction firms with infrastructure projects in Libya led losses. European bourses slid for a third straight day, with the Euro Stoxx 600 down 0.9%, led by losses in airlines as oil prices push to a two-and-a-half year high over supply concerns. Elsewhere, profits are being taken in industrials with a sharp drop in aluminum, while silver and gold have fallen back after reaching new highs.

Global bond markets are solidly higher as flows leaving equities are finding a home in bonds. The story in the rate markets are all about safe haven flows as benchmark US yields are at a three-week lows, with the 10-year down 8bps and the 2-year down 5bps. Bunds and gilts continue to rally as well; with bunds underperforming gilts after ECB’s Mersch suggested that the ECB will lift is inflation forecast next week. Elsewhere in Europe, periphery yields are marginally higher following Spain’s bill auction. In Japan, meanwhile, the 5-year CDS touched its recent high of 80bps following the debt downgrade, while the RBNZ’s rate hike expectations over the next year were slashed by nearly a full 25bps.

Currency Markets

The events in the Middle East and Northern Africa are the main spur of market action. The position adjusting pressures that had sent the euro nearly two cents from the high seen earlier yesterday ran into hawkish comments from ECB’s Mersch that spurred the short-covering bounce in mid-morning turnover in Europe. Mersch hinted that the ECB may raise its inflation forecast and in effect adopt a tightening bias, within its "no pre-committing" framework. Yet in some ways Mersch’s comments are not new in substance and recent official comments have played up the upside risks to inflation. With oil prices at two year highs and given the ECB’s penchant for viewing higher oil prices as inflationary, the ECB’s rhetoric has taken a more hawkish turn of late.

While events in Libya are dominating considerations at present, the "jasmine revolutions" are sweeping across the region. Both Libya and Bahrain were downgraded yesterday (Fitch and S&P respectively). S&P followed up with a cut of Libya’s credit rating today and placed it on negative watch. News reports suggest Egypt has asked the EU for debt forgiveness. The events in Egypt may have helped embolden others and the unrest appears to be spreading, with the Ivory Coast, being impacted today. These political events are having an economic impact. First, it is sparking an oil shock that could act as a headwind to the world economic recovery. Second, it is exacerbating the broader commodity shock directly and indirectly. Note that modern agricultural production is very energy (oil and natural gas) intensive. Third, it is prompting a retreat in equity prices, which impacts household net worth, consumer confidence and the cost of capital.

Two other events are on radar screens today. Moody’s lowered its outlook for Japan’s AA2 rating to negative, citing concern that its fiscal policy is not strong enough to stabilize the debt/GDP ratio. However, the rating agency acknowledged that the world’s third largest economy does not face a funding crisis in the near/medium terms. A decision on Japan’s rating is unlikely to be made before the government unveils its tax and welfare package near midyear. Although Japan funds its budget with domestic savings, many economists project that at some point in the second half of the decade, domestic savings will not be sufficient. A faction within the ruling DPJ is aiming to block the government’s budget plans and it will be interesting to see if the suspension of the rival leader Ozawa has much impact. While Japanese equities fell in line with the region, Japanese bonds seemed largely unaffected by Moody’s decision, as safe haven considerations dominated. The price of credit default swap (5 yr) rose a couple of basis points. New Zealand’s second largest city, Christchurch, was hit by a 6.3 (Richter scale) earthquake that the Prime Minister called "utterly devastating", prompting a recalibration of the outlook for rates.

The European debt crisis remains unresolved. Of note, the head of the European Bank for Reconstruction and Development seemed to suggest what many in the markets have suspected: a restructuring of Greek debt is nearly inevitable. Mirow told a German paper that Greece cannot bear debt/GDP of 150%. Meanwhile, EC and ECB officials continue to visit Portugal to assess their public accounts and strength of the financial industry. Remember Portugal’s debt problems are not (yet) concentrated in the public sector, but rather private sector. This means that although Portugal is reporting that its deficit reduction program is indeed being implemented, the market is giving the country little reprieve. On the other hand we note that there is goodwill building toward Spain and this is being reflected in a de-coupling of Spanish bonds from Portugal. As Ireland got assistance last year, Spain and Portuguese bonds were correlated 0.8 (on a rolling 60 day basis) that correlation is below 0.2 today. That said, it appears to be rising in recent days, with this week’s election the next hurdle.

Upcoming Economic Releases

At 9:00 EST / 14:00 GMT the US reports the Dec Case-Shiller housing prices (-0.5% m/m vs. -0.54 prior) followed by February consumer confidence (65 expected vs. 60.6 prior). Canadian Dec retail sales at 8:30 EST / 13:30 GMT (0.0% m/m vs. 1.3% prior) Events: BoE’s Adam Posen at 12:00 EST / 17:00 GMT, Fed’s Kocherlakota (FOMC voter) at 1:00 EST / 18:00 GMT.