Dollar Extends Gains on Euro Zone Woes

BBH CurrencyView

• The dollar is stronger across the board as periphery strains and soft data weigh on euro
• This week US data is likely to remain mixed and limit euro’s slide; China’s flash PMI moderates
• Our sovereign ratings model suggests that the downgrade of Italy was unwarranted

The US dollar is stronger across the board as the crisis of confidence in the EMU continues to accelerate. The euro slumped to a record low versus the Swiss franc, while dipping below the $1.40 level for first since March as concerns in the euro zone have led to renewed risk aversion. Sterling followed the euro lower, moving back towards the $1.611 level after falling back from $1.625. Against this backdrop the yen and Swiss franc rallied sharply, while the broad move into safe havens weighed on commodities, equities and growth sensitive currencies. Oil prices are down 2.4%. Asian equities plunged, with regional benchmark dropping to a 2-month low as the MSCI Asia Pacific index fell by 2.2%. Losses in Asia were compounded by the moderation of China’s flash PMI. In the same way, the Euro Stoxx 600 is down 1.3% after having made a 1-month low. Amid the stockmarket selloff and widening of periphery yields spreads, bund and gilt futures hit new contract highs, while the US 10-year yield came within a whisker of last week’s trend low.

Euro zone political issues continue to remain an important downside risk for the euro and are likely to pose a potential temporary headwind for the euro, despite the supportive outlook for the ECB. The ongoing debate over Greece’s unsustainable debt trajectory, coupled with news over the weekend of S&P’s downgrade of Italy’s rating outlook have the potential to continue to weigh on euro zone market sentiment as the sovereign issues remain on the fore front of investors’ minds. Softer than expected PMI data this morning has compounded these fears. Equally, important, further periphery strains are in turn likely to lead to a flight to quality of German bonds, which reduce the relative interest rate spread between the US and Germany and thus support the dollar. The 2-year German-US spread, for instance, has narrowed by 11bps over the past three trading days, coinciding with the euro’s 2% loss. In the week ahead many will also be focused on the other political issues in the euro zone, including the ramifications from the both the Spanish and German regional elections, with the former likely to stoke concerns over Spain’s commitment to fiscal austerity. At the same time, there are some important economic data releases this week in the US, which are expected to indicate that the pace of US economic activity is likely to have slowed and may limit the euro’s losses. Wednesday’s durable goods report, for example, is expected to decline from the previous month and more importantly the expected marginal rise in core PCE is unlikely to threaten a change in the FOMC’s dovish posture, which is key to the expected dollar weakness over the medium term. While Thursday’s Q1 second estimate of GDP is likely to increase from the previous quarter, the recent string of disappointing US data may lead to a weaker than expected print. Taken together, while we expect the euro extend its gains over the medium-term as we look for interest rate differentials to reassert themselves, over the course of this week we expect the euro is unlikely to break the upper end of its recent range near $1.450 with a break of the lower range near $1.395 likely to lead the euro to test levels near $1.390.

While we remain negative on the ratings for peripheral euro zone, we don’t think a downgrade of Italy by S&P is clearly warranted. Our sovereign ratings model currently has Italy at A+/A1/A+ vs. actual ratings of A+/Aa2/AA-. Moody’s is most out of line but S&P appears to be on target and Fitch is off by one notch. If anything, we had expected a move by either Moody’s or Fitch, not S&P. With rating agencies still clearly on the warpath, we can’t rule out a downgrade here, but the case for a downgrade of Italy just isn’t as glaringly obvious as the others in the periphery. Clearly, the downgrade story will remain in play for the periphery for much of 2011. Other weak euro zone credits to watch out for are Belgium and France, with both facing some mild downgrade pressures. Our model has France as a borderline AA+/Aa1/AA+ credit vs. actual ratings of AAA/Aaa/AAA, and also has Belgium as a AA/Aa2/AA credit vs. actual ratings of AA+/Aa1/AA+. Last week’s downgrade of a major French bank due to its exposure to Greece is a warning sign that the sovereign rating itself for France may come under greater vulnerability. With regards to Belgium, we suspect that if there is still no government in Belgium by mid-June, it will likely be downgraded by S&P, which it threatened to do near the start of this year. In other words, it is possible that the next country that gets their rating cut could very well be a core and not a peripheral country. That would certainly get the market’s attention.