Dollar Begins Week Firm as Sentiment Sours Ahead of Summit

BBH CurrencyView

• Dollar and other safe havens remain firm amid EZ uncertainties; stocks and commodities retreat
• The week ahead is likely to be dominated by EZ summit, debates surrounding US budget and earnings
• EM investors continue to focus on the collateral damage of the EU crisis on Eastern Europe

The dollar begins the week with a strong tone as markets remain cautious about lingering uncertainties surrounding the new bailout package for Greece ahead of this week’s euro zone summit. The euro broke below Friday’s low and continues to decline amid the ongoing uncertainty in the periphery (with 10-year Spanish and Italian yields fast approaching 7%) as risk aversion prompts demand for German bunds. As a result, the 2-year German-US interest rate spread reached a new low near 83bps, which are levels not seen since late February and in part remains a dominant driver of the euro’s weakness. Against this backdrop the Swiss franc and the yen remain supportive, with the EUR/CHF reaching a new record low of 1.137 this morning. Sterling remains mixed, lower against the USD but higher against the EUR as investors flock to the relative safety of gilts. Asian stocks markets closed mostly lower, with the MSCI Asia Pacific index showing a 0.5% loss, while Japanese markets were closed for a public holiday today. News that Beijing is planning further tightening measures in the Chinese property markets saw the Shanghai Composite give back earlier gains that edged out a new two-month peak. Europe’s Stoxx 600 retreats for the third straight session down over 1% led by the 2% decline in financials.

The week ahead is light on macro economic data, but for sure developments surrounding the outcome of the euro zone summit, the US fiscal impasse and Q2 earnings are likely to remain the week’s dominant drivers. Over the past few weeks the euro has been plagued about uncertainties over the involvement of private bondholders in the Greek bailout, which has led to tensions in some of the other non-core bond markets –namely, Italy and Spain. In terms of the details of the Greek bailout deal, investors are likely to expect an increase in the Greek financial rescue package, along with more clarity on the role of private sector involvement. At the same time, investors are likely to hope for more workable strategies to limit contagion risk, which is likely to include purchases of EZ government bonds by the EFSF, but uncertainty over this proposal looms as Germany remains staunchly opposed to any form of fiscal transfer from the core to the periphery. The euro’s price action this week will be predicated on the outcome of these events (along with a couple of important data reports that are likely to soften from the previous month), with the most positive outcome likely to entail an extension of the size and scale of the existing bailout facilities to allow purchases of peripheral debt on the secondary market. While this outcome is likely to support the euro in the near-term as it reduces market uncertainties and thus lowers the risk premium for holding the euro, politics is likely to be the major hurdle to success. As a result, we expect the euro to remain defensive and likely confined to the lower end of its recent range of $1.385 – 1.43 ahead of the meeting. European bond supply and economic data also pose downside risks for the euro this week as well. Yet we suspect that the debt ceiling impasse in the US is unlikely to provide much support for the dollar either, which is likely to limit the euro’s downside. As such, we expect the CHF and JPY to continue to outperform. In addition, markets are also likely to focus on Q2 earnings this week with IBM, major US banks, Microsoft and GE all due to report. On the data front, second tier US will be reported this week with Thursday’s Philly Fed report likely to be of key importance, along with housing starts and existing home sales, which are unlikely to be supportive for risk appetite.

In the absence of any market moving news or data, EM investors continue to focus on the collateral damage of the EU crisis on Eastern Europe. The appreciation of the Swiss franc is the main channel of contagion with the focus on FX-denominated loans in Hungary and Poland. But selling pressure is spilling over into ZAR and TRY. In Turkey, the market remains concerned about the medium-term consequence of the central bank’s unconventional policy. In South Africa, the economy remains weak and has more recently been plagued by strikes. Steel sector workers ended their strike on Sunday but the strike by oil industry workers are entering in their eighth day, leaving the nation’s fuel pumps dry. Of note, the central banks of Turkey and South Africa meet this week, with both expected to remain on hold, but their statements will be carefully scrutinized for any change in the outlook and hints of hawkishness.