Pre-Market: Policy Paralysis on Both Sides of the Atlantic

BBH CurrencyView

• Market anxiety over the US political gridlock and EZ periphery kept asset markets on the defensive
• Lukewarm bond auction in Italy and rise in periphery yields fueling accelerated safe haven activity
• The day after Brazil’s new marco prudential measures; China’s midyear review of the CBRC

The market’s anxiety over the implications of potential US downgrade (and a catastrophic default) has reached a new phase, as the self-reinforcement of negative sentiment has led to renewed spike in EZ periphery yields. EZ jitters kept the EUR defensive throughout the night, but it was a sharp rise in Italian refinancing costs at today’s auction that fueled accelerated safe haven activity. As a result, EUR/CHF fell sharply to 1.142 lows and was the catalyst for the nearly 0.5% loss in the EUR/USD. Sterling was also heavy around 1.630 on dollar repositioning, while more weak UK data reinforced underlying difficulties in the UK economy. Surprisingly, the dollar bloc continues to maintain an overall supportive tone, with the NZD the best performer in the G10 on the day after the RBNZ likely signaled a move in September. Global stocks remain on offer, with both Asian and Europeans stocks declining for the second consecutive day amid the sharp deterioration in sentiment. Elsewhere, oil prices found a modicum of support after the threat of supply disruption fueled a rebound to $97.43.

Price action in the FX markets has taken a decisive turn from the beginning of the week as dollar diversification had dominated market actions earlier this week. And now investor’s fear over the impact of a looming US downgrade (and a potential default) on financial balance sheets and riskier assets has now taken the upper hand, boosting the dollar. In short, asset markets have shifted from broad dollar diversification to “risk off” again. At the same time, the combination of “risk off” and the renewed fears about the funding situation in the euro zone periphery following this week’s lukewarm bond auctions in Italy and Spain have continued to weigh on the euro. Indeed, one scenario suggests that Italy and Spain continue to remain under pressure this week, as investors realized that last week’s debt deal does not solve the euro zone’s underlying problem, nor does the lack of “top up” in the EFS funding requirements garner much confidence that if tapped the fund would be able to provide the desired liquidity. As a result, the euro has come under renewed pressure against the CHF, JPY and even the growth sensitive currencies like the AUD and NZD – which are likely supported through their demographic links to Asia. The channel of renewed euro weakness has in part remained unchanged for quite some time and is likely a combination of the relative 2-year interest rate differential and the marked selloff in equities. In fact, the former has seen the 2-year relative interest rate spread fall to a new 5-month low of roughly 81bps, driven by the flight to quality of German bunds amid the rise in periphery yields, while the Euro Stoxx 600 Banks index has fallen by nearly 9% since its recent peak on 7/22. Further escalation about the funding situation in the EZ periphery and political gridlock in the US are likely to lead to a negative reinforcing prophecy, where more concerns over a potential US default could fuel investor’s fears and weigh on risk appetite and the performance of risk sensitive currencies. All told, a resolution over the potential default of the US would likely alter this downward spiral but nevertheless the euro should remain confined to recent its recent range.

The day after the new measures will give the government only limited satisfaction. USD/BRL spot closed back above 1.55 (a 1% move) but was well off its intraday high of 1.5704. Implied BRL yields on local FX contracts were volatile, but moves were not extraordinary. There is no evidence (yet) that we are about to revisit the stressed levels observed in late April. The Bovespa outperformed the S&P. The key thing to remember now is that the new measures give a lot more power to the National Monetary Council, serving as an implicit threat to markets and likely to keep BRL on the defensive for now. Meanwhile, the mid-year review of the China Banking Regulatory Commission (CBRC), the country’s banking watch dog, was released yesterday. Chairman Liu Mingkang made headlines by focusing on the risks associated with funding vehicles. He urged banks not to extend loans or rollover debt instead of settling their obligations. He also discussed the illegal flow of loans into the housing market through individual loans and mortgages for commercial property, but pushed for a greater emphasis on social housing. The first headlines of the Turkish CB’s quarterly inflation report have just been released. No signs that the bank is taking into account the risks of overheating that the market are focused on. All told, target rate hikes are unlikely for now, even though we still think they will capitulate on this conviction at some point. They may be considering regulatory measures, be we have heard nothing about this yet.