Risk Appetite Firm as Markets Await ADP

BBH CurrencyView

• US dollar is mixed; ADP report likely supportive of USD against JPY and CHF
• Swiss KoF leading Indicator reaches four and a half year highs
• Euro softer on the day but remains resilient in the face of continued downgrades

The dollar is mixed, falling against AUD and NZD while rising against JPY amid recovering risk appetite. USD/JPY rose 0.7%, trading around the ¥83 level, while AUD/USD is up 0.2%, making fresh highs of $1.033. EUR/USD remains little changed into the North American session, down 0.2%, while sterling benefited from M&A related flows and supportive UK data, which lifted sterling through $1.605. European equity indices are higher with the Dax up the first time this week while the Nikkei closed 2.6% higher, boosted in part by a resumption of production. S&P futures up 0.5% as well. Global bond yields are mostly higher as stocks rallied, softening demand for safe havens.

Switzerland’s leading economic indicator remained strong in March, reaching the highest level in four and a half years. The KoF came in at 2.24 in March versus 2.19 in February, which was much better than expected and indeed will underpin the outlook for the SNB going forward. In fact, the latest readings of the KoF and PMI are consistent with robust Swiss GDP, upwards near 2.8-3.1% GDP. But overall in the short-term the Swiss franc is likely to be driven by the market’s risk appetite and the progression of the European debt crisis, not the outlook for the SNB. For one, interest rate differentials support euro strength as the 2- and 10-year interest rate differential has continued to move in the euro’s favor as the market expects the SNB to lag the ECB. According to the implied pricing of overnight OIS swaps the ECB is expected to hike by 125bps this year while on the other hand the rates market has only 62bps of tightening priced into the Swiss curve. In addition, the CHF has softened lately as the moderation in volatility and return of risk appetite has dampened the demand for safe haven assets. After touching recent highs in the wake of the Japanese crisis and geopolitical tensions, USD/CHF three-month implied volatility has fallen nearly 9% since the height of the crisis and by over 1.5% in the past week alone. That means a reduction in implied volatility and a slowdown in deleveraging is likely to see the CHF underperform in a risk-on environment, supporting the CHF’s historic roles as a funding currency. Indeed, recent CFTC futures suggest that investors have pared back their CHF longs while risk reversals confirm that the cost of CHF puts have increased. Today, the USD/CHF is likely to be supported by the upside cross of the 5- and 20-day moving average with a strong ADP jobs report pushing the pair to test the recent high near 0.925.

EUR/USD remained resilient in the face of another S&P downgrade to Portugal and Greece, though peripheral bond and CDS prices moved in response. This pattern is likely to persist as long as markets have confidence in the solvency of Spain. Spain’s 5-year CDS, for example, has fallen by 138bps since its recent peak in early January. The euro remains supported by interest rate expectations as ECB President Trichet has continued with his hawkish comments this week. Still, Portuguese 10-year yields closed just below 8.00% yesterday, after rising for the 6th consecutive session while the 5-year yield has breached 9% – a euro area peak. The government seems to need around €1 bln to meet next month’s coupon and redemptions. There is some talk that it may seek a bridge loan, buying it time until the nearly €7 bln are needed in mid-June. On the other hand, Irish 2-year yields declined 30bps ahead of the Irish bank stress test results scheduled to be released on Thursday. Markets are speculating about a medium-term ECB financing facility for its banks. Irish Life & Permanent was the latest bank to come into focus and is likely to require more government support soon. More broadly, bank stocks in the European periphery are likely to remain under pressure after yesterday’s announcements of larger-than-expected capital needs for Italian and Spanish banks. The Italian and Spanish banking sectors declined 3.5% and 1.2% yesterday, respectively.