ECB and Portuguese Deal Keep Euro Firm

BBH CurrencyView

• Dollar mixed against the majors; ADP and ISM services unlikely to provide support for USD
• China’s central bank reiterates inflation priority; risk appetite mixed
• Euro approaches 18-month high ahead of ECB meeting; Portugal strikes €78bln aid deal

Negative risk sentiment abated from the overnight session with many equity markets moving into the black and the USD paring its gains against most major currencies. The euro remains firm though as it approaches an 18-month high following the announcement of the Portuguese bailout, while sterling followed the euro higher, despite another round of disappointing economic data. Asian equities extended Tuesday’s losses, forcing the MSCI Asia Pacific to its biggest loss in three weeks as profit taking accelerated, while European bourses are flat to 0.5% higher. A reversal of intra-euro zone safe haven flows is adding to pressure on bunds (2-year yield up 5bps) as euro zone spreads narrow on the back of the Portugal bailout, coupled with the expectations of a hawkish ECB tomorrow. Weaker than expected services PMIs and retail sales failed to give lasting support, though. Energy prices and gold are flat, but silver continues to tumble, falling over 2% today.

China’s central bank reiterated that inflation is the bank’s top priority and so markets are preparing for further tightening in China. This is not the first time that PBOC officials have made comments about inflation or another key goal, to reign in property prices, so the purpose appears to be to signal markets of what is to come. Chinese newspaper headlines today included that reserve requirements will be boosted again in May and that property market controls will be extended to additional cities. Chinese stocks were down over 2%, with basic materials the worst performing sector, down 3.8%, and the MSCI Asia index was down 1.5%, as equity markets see tightening resulting in slower growth and lower profits. Chinese stocks are at 2 month lows. Over the last 6 months China has raised rated 4 times and increased reserve requirements to a record 20.5%. Chinese manufacturing PMI for April was weak, on the back of this tightening. Services PMI comes out tonight. Next week China and the US have their strategic economic dialogue. Before such meetings China historically allows for additional CNY appreciation, and in just over a week, CNY has appreciated by 0.5% vs. the dollar, to the current 6.5010. We expect the government to increase the use of an appreciating currency as a tool to slow inflation, and thus see CNY appreciation to pick up to over 5% during the next 12 months, beyond current forward pricing of 2.8%.

The euro continues to surge this morning, trading ahead of $1.49, despite some US short covering against some of the majors and a mixed tone in risk appetite, buoyed by a combination of drivers. For one, many see the risk premium in the periphery fading, at least in the near-term, with the procurement of the 3-year, €78bln bailout of Portugal leading to a sharp decline in the price of most of the euro zone periphery’s CDS price. Portugal’s 5-year CDS price, for example, is down 33bps on the day as the yield on the 10-year dropped 18bps. While the Portuguese bailout includes a goal to reduce the government’s deficit from a planned 5.9% of GDP in 2011 to 4.5% in 2012 and 3% in 2013, the agreement is much favorable that many had anticipated, in terms of size and duration. However, some important details of the deal are unknown (such as the interest rate and details of the expected austerity measures) as the final talks with the opposition are still required. In the end, though, we expect the measures to pass with some minor tweaks possible. The second driving force (which is likely to boost the euro through $1.50 this week) continues to be the policy trajectory of the ECB and in turn the relative 2-year interest rate spread between Germany and the US. Specifically, the 2-year German-US yield spread is roughly 132bps as the spread approaches highs not seen since December of 2008. At the same time, the catalyst for the shift in the ECB policy language and indeed for the shift in overall policy towards normalization has been the combination of higher commodity prices, leading in turn to worries about second-round effects, and strong economic data in the core. In our view, these effects are likely to prompt a hawkish response from Trichet in the post meeting press conference tomorrow and indicate that the next 25bps hike is likely to take place in June or July, with the rates market beginning to lean towards June. With US data likely to be on the soft side this morning a break of the $1.49 level is likely to trigger a run towards $1.51.