A Temporary Sigh of Relief?

BBH CurrencyView

• Safe havens trade on the back foot as risk appetite resurfaces; BoC expected to remain on hold
• Options pricing suggests that the market is prepared for the worst ahead of Thursday’s summit
• In the EM space macroprudential measures in Korea and Brazil return to the fore

The dollar pared back some of its recent gains in Asia, which carried over into the European session, driven by the resurgence of risk appetite. The market optimism was spurred by a combination of better-than-expected earnings results, hopes that European policy makers would reach a solution on Greece this Thursday (reducing the euro risk premium) and the outlook for the US debt ceiling negotiations. As a result, the euro traded above $1.42 after gaining traction from the crosses, while Swissie fell back sharply, which saw the USD/CHF hit recent highs and the EUR/CHF surge through 1.16. Sterling rallied on the euro’s coattails and tested offers towards 1.6160 and Aussie overcame a less hawkish RBA tone to trade back to 1.067. Global stocks were mixed as Asian stocks traded defensively, with the Nikkei down 0.6% after returning from holiday, while European shares benefited from good earnings results, which lifted the Euro Stoxx 600 from 7-month lows. Elsewhere, we expect the BoC to remain on hold.

Ahead of this week’s emergency summit, the markets are likely to look past European economic data and instead focus on the event risk of the summit along with sovereign debt issuance by the periphery and earnings. Today’s Spanish auction confirmed that despite solid demand for its debt, the inexorable rise of primary market debt costs continue. In our view, the short-dated tenors of the auction likely added to the success, given that short-dated bonds carry significantly less duration risk. Still, the fact that Spain didn’t sell the full amount and that refinancing rates are rising sharply highlights that pressure on Spain remains. Notwithstanding, the Spanish auction results and the weaker-than-expected German ZEW the euro has gained some support on a combination of factors, which are likely to keep it bid into the North American session if risk appetite continues to improve. For one thing, key driver for the euro as this juncture appears to be the fact that the market is not positioned for a positive outcome at this week summit. Indeed, while the outcome is likely to provide asymmetric risks – where the scale of a potential negative reaction to a lack of progress far exceeds the positive reaction to a deal – the options market is currently braced for the worst. Short-dated 25D risk reversals, for instance, are heavily skewed towards euro puts, with the spread to calls nearly at all-time record highs. This is an indication that the options market is positioned for the worst so the euro is likely to benefit from positive news ahead of the summit. Three deals are currently being debated (debt buybacks, Vienna Initiative and tax financial sector, similar to a Tobin tax) with the combination of continued positive earnings surprises and positive developments ahead of the summit likely to boost the euro, although a convincing break of $1.421 is needed before a test of $1.43. Negative news ahead of the summit, however, is likely to push the euro towards $1.39

Macroprudential measures in Korea and Brazil were the major theme overnight, though neither have any obvious consequence for FX markets. In Brazil, the central bank (BACEN) tightened rules on payroll-link borrowing (credito consignado) through credit cards. Banks are now required to hold double the capital backing these loans. While these recurring macroprudential measures may have a negative short-term impact on equity markets, we think they are important to fend off concerns about a credit bubble forming in Brazil. Where we think the BACEN went wrong is when it articulated these measures with its inflation objective, thereby trying to avoid hiking interest rates. Our impression is that BACEN is ahead of the curve regarding the credit risks in Brazil, which are not negligible, but seem to be under control. It is interesting to note that foreign analysts seem to be far more concerned with the credit risks in Brazil than the locals. In Korea, the government clamped down on the so called Kimchi bonds, which are foreign currency denominated bonds issued onshore. The proceeds from these bonds are typically swapped into KRW. The measure is likely to affect the KRW cross currency basis swap market more than the spot FX market. The objective is to get local firms to raise funds in won when they intend to use them domestically. The measure is in line with the recent efforts to reduce foreign borrowing in the banking sectors, which the government perceives as an important risk to the system.