Pre-Market: The US Muddle Through Approach

BBH CurrencyView

• Dollar pares back recent losses against majors but remains defensive; stocks and commodities down
• Even if default is averted odds remain high that US credit is downgraded by at least 1 of 3 agencies
• South Korea’s GDP decelerates in Q2 from Q1; Swiss KOF slows while Australian CPI accelerates

The dollar has pared back some its recent losses against some of the majors but its posture remains defensive as markets grow increasingly nervous about the lingering debt issue. Overstretched positioning and pressure on the periphery encouraged some light profit taking, with the euro down 0.3% but the impasse over the ‘ceiling’ debate is likely to limit downside momentum. Sterling is down in part from weaker UK CBI manufacturing orders, while the weakness in the KOF leading indicator highlights the waning momentum in the Swiss economy driven in part by the roughly 9% appreciation over the past 7-months in broad trade-weighted CHF index. The yen is marking time near 77.80 after briefly making a recent low near 77.57. European stocks declined for a third day (led by a 2% in banks) amid weaker than expected earnings and lingering doubts that last week’s aid deal is sufficient to prevent a repeat of the crisis. As a result, bund and gilt futures continue to rally, with oil prices down.

The political gridlock in the US continues afoot, keeping the dollar generally weaker against most of the majors and even against some EM currencies. Against this backdrop, it is quite interesting how quickly the currency market has shifted its focus from the EMU sovereign debt crisis to the US debt issue. The dollar, in large part, is consolidating some it recent losses this morning as central bank reserve managers are likely intervening to stem their own currencies from rapidly increasing, while the dollar bloc continues to advance amid broader currency diversification strategies. On balance, it appears likely at this juncture that even if an agreement is forged between the political parties, it would not unreasonable to assume that the US still faces a high probability of a ratings downgrade. The Reid and Boehner proposals, for example, both fall short of the minimum standards put forth to avert a downgrade by at least one of the major three rating agencies. In fact, a recent newswire poll found a majority of economists expect the US to lose its AAA credit rating from one of the three big rating agencies, along with a 20% chance of a new recession over the next year, driven in part by the acrimonious political debate over the legislative vote on the debt. Some observers believe that there are likely to three key scenarios to play out given the heightened odds of a looming downgrade, including 1) the 11^th hour grand bargain that averts a downgrade and default 2) the “muddle through” approach, which averts default yet leaves the US on a fiscally unsustainable track that eventually leads to a downgrade and 3) a US defaults. In our view, scenario two is the most likely outcome and while a brief USD relief rally is possible, it is likely to be short-lived. Indeed, it appears based on the recent price action that FX markets reflect investor’s forward-looking nature to focus on the negative implications ahead for the USD if this scenario emerges. That said, while a downgrade would be negative for US equities it is unlikely to derail global risk appetite and as a result we expect the dollar bloc, scandis and EM currencies to advance, with the euro expected to remain in its recent range.

The main news overnight was Korea’s GDP release which showed a deceleration in economic activity from 4.2%YoY in Q1 to 3.4%YoY in Q2. But inflation remains the main concern and has become a highly politicized issue. The BoK is likely to continue tightening going forward, boosting the KRW. However, with KRW now below 1050 for the first time since August 2008 the risk of move vigorous action in the FX markets through spot intervention and/or regulatory measures increases. In the short term, we think the risk reward favors currencies like the INR over KRW. Indeed, could be a good point to start building long positions in INR/KRW as it moved off its lows and about to test the 50-day MA once again. Elsewhere, Swiss July KOF leading indicator disappointed, coming with a headline reading of 2.04, below the median forecast of 2.09 and after 2.23 last. At the same time, there has also been signs that the strong currency is starting to bite, such as June trade data that showed that the surplus shrank to CHF1,745 mln from a revised CHF3,254 mln in May on the back of a bigger fall in exports than in imports. The currency’s trade-weighted value surged through May and June, and extended higher in July, driven by safe haven flows as the euro zone debt crisis escalated. Meanwhile, Q2 Australian CPI beat expectations, following the 1.6% surge in Q1, with the pickup in core inflation a high hurdle for prospective rate cuts this year. Indeed, today’s inflation is a possible harbinger for a Q4 rate hike and despite the AUD’s recent decoupling from the rates market a shift in the market’s rate expectations from a cut to hike is likely to underpin AUD moving forward.