Contagion Fears and China Hike Spur Dollar Demand
BBH CurrencyView
- Dollar is broadly firmer for the second day on euro zone periphery issues; China hikes rates by 25bp
- Safe havens are bid again as downgrade of Portugal fuels concerns over status of Ireland’s rating
- Brazil Finance Minister Mantega speaking yesterday was back on his campaign against BRL strength
The dollar is broadly higher for the second straight day as the European session was dominated by increased fears of euro zone contagion after the Portugal downgrade prompted fears that Ireland (and perhaps Italy) is next. The euro declined in part amid renewed tensions in the periphery debt market (along with banking sector concerns) with losses accelerating after the market run-up in periphery yields and CDS pricing. As a result, EUR/CHF dipped below 1.207, which marked losses of just over 2% since yesterday’s Asia open, while sterling advanced 0.4% against the euro. The yen drifted back towards 81 against the dollar after it benefited from dollar short covering amid a rise in risk aversion. Late in the European morning China hiked interest rates by 25bp, effective Thursday, which was the fifth hike since September and helped underpinned the dollar’s firmer tone. It also weighed on equity markets, but stocks were already struggling since the European session got underway, with European financials leading losses in the Euro Stoxx 600. Asian stock markets were mixed today, while China’s banking sector underperformed after yesterday’s Moody’s warning on local government debt.
While this downgrade shouldn’t come as much of a surprise, it is remarkable how the agency has front run contagion risks amongst periphery countries even before the Greek deal was finalized and possibly ahead of the market. According to a senior analyst at Moody’s, the downgrade was in part premised on the direction the Greek bailout is moving in terms of private sector participation. Moody’s also warned that Portugal may not be able to achieve its deficit reduction targets and that there was “the increasing probability that Portugal will not be able to borrow at sustainable rates in the capital markets in the second half of 2013 and for some time thereafter.” We do agree with the assessment and suspect that it is likely that Ireland is next in the cards for a downgrade but do not expect these events to derail market sentiment completely. The risks today, though, are that the downgrade highlights reoccurring doubts about the ability of euro zone policy makers to ring fence contagion and in turn stymie the eroding market confidence. As a result, the euro periphery spreads widened out again and investors flocked to the safety of German bunds. In the same way the weakness in risk appetite over the past two months coincided with deterioration in the macro picture, which exasperated the decline in market confidence amid the flare up in the Greece. Taken together, while we suspect that an improving marco picture (with positive US data surprises essential) would likely remain supportive of the euro, lingering concerns about the prospects for the periphery are likely to keep the euro defensive and confined to it recent ranges, with the next level of support seen near $1.43 and a convincing break of the trend line near the recent high needed to reach the $1.475 level in the coming weeks.
Brazil Finance Minister Mantega speaking in London yesterday was back on his campaign against BRL, again talking about measures in the derivative markets to contain appreciation. As we have been warning, it is a question of time – or rather, level – until they act again. But it is unclear where the new line in the sand is. The most likely candidates are USD/BRL 1.55 or 1.50, but it probably depends on the speed of BRL appreciation. In the short term, the risk-reword for going long BRL at these levels is not there, in our view. Ultimately, however, we think USD/BRL is heading lower towards and perhaps beyond 1.50. Turning to China, Premier Wen Jiabao repeated that managing inflation the government’s top priority, likely in an attempt to clarify speculation that the government is shifting away from tightening in a significant way. As we have noted in the past, we think tightening in China will continue – albeit with less emphasis on reserve requirements. But we also believe that other policy priorities are rising in importance, notably the functioning of the inter-bank market and credit availability to small and medium businesses. Also of note, USD/PHP keeps trending lower, reaching 42.8, the lowest level since May 12. The moves are largely driven by expectations for further tightening by the central bank as CPI rises to 5.2%yoy. The risk here is that the banks opts to emphasize using reserve requirements instead, a strategy that Governor Tetangco has been hinting on recently.
I do get annoyed when there is talk of contagion. If the financial sector is weak then it has already being infected. Using the infection analogy they are just carriers of the disease that have not yet succumbed. In terms of contagion you should included France, German, Belgium and Netherlands. The UK has already been affected by the collapse of RBS and Lloyds TSB banks, but will have a relapse if Ireland defaults. That will trigger billions of losses in RBS and claims on the British government. Yet if that happened then the talk will be of contagion of the UK but it was already present. Only if Ireland defaults and UK banks cope will we be in the clear. That said when Ireland defaults I suspect that our leaders will rush us faster down the road to austerity, and disaster.
If the medical analogy is used then the only countries that cannot be infected are those that are isolated from international banking. Lebanese banks while connected have super high reserve requirements so cannot be infected. Australian banks will not be affected in the same way. They have significant risks but they are all domestic. So contagion is not like a disease.