Market Sentiment Remains Poor Ahead Of FOMC

BBH CurrencyView

• Sentiment remains poor ahead of FOMC meeting; safe haven trades to remain in favor
• Euro zone remains under pressure despite ECB purchases of Italian and Spanish bonds
• China data supports soft landing thesis; Asian central banks intervene to limit FX weakness

Negative sentiment continues ahead of FOMC meeting. Markets remain volatile and indecisive through the London morning, with the dollar mixed against other major currencies and S&P futures swinging from gains to losses in a 6% trading range. EUR/USD is slightly higher at 1.4270, while CHF and JPY are up 1.6% and 0.7% against the dollar, respectively. EUR/CHF continues to make new lows daily, dropping below 1.05 today. AUD and NZD are the greatest losers, falling around 1.5% against the USD, but recovering from drops below key 1.00 and .80 vs. USD, respectively. ECB periphery debt buying continues to support Spanish and Italian bonds, with yields falling 17 and 20 bp in the 10-year sector, respectively. S&P futures are pointing to a small positive open but European bourses are lower by as much as -3.5%. Energy prices continue to collapse, leading Brent futures down another 2% to $101/barrel. Gold is up once again to $1768/oz. EM FX to remain under pressure.

Markets await FOMC decision today and risks are tilted towards disappointment. While we think that the Fed will have to respond to evidence of a slowing of the US economy, it is simply running out of policy levers to pull. What can it do? The Fed will likely downgrade its assessment of the economy and lower its GDP forecasts for this year and next. However, we expect the policy response to take the form of explicit language assuring investors that rate changes will not be forthcoming and may even set a defined period. The Fed is also likely to extend their securities portfolio from shorter maturities to longer maturities, with the intention of inducing a flatter yield curve. It is possible that the Fed also announces an explicit yield target for specific maturities. We do not expect the Fed to renew its Treasury buying operation (QEIII) or to buy non-government obligations (such as corporate bonds or equities), as some have suggested. This may eventually happen, but not at today’s meeting.

European stresses to continue. Press is making some hay today about German CDS prices now being equal to UK CDS prices. S&P made some supportive comments on UK’s AAA rating as well. This makes no sense at all to us, especially in the wake of the US downgrade. We have long focused on deteriorating UK fundamentals and have highlighted downgrade risks, as our sovereign ratings model puts UK at AA/Aa2/AA vs. actual AAA/Aaa/AAA. Germany is a solid AAA credit, and while its fundamentals may be dragged lower as it has to backstop more and more countries, we do not see any loss to its AAA rating in the foreseeable future. There appears to be an anomaly in the relative CDS prices that we think cannot be sustained. We also disagree with S&P’s supportive comments on France, since we see it as the weakest of the AAA credits and believe it to be in danger of downgrade.

Weak IP data out of the UK today underscores the fact that fiscal tightening will be harder and harder to achieve. Also, the ongoing and deepening riots suggest that the very social fabric is in great danger of tearing under the weight of austerity and slow growth. NIESR UK growth estimate is out tonight and there is a chance it will show a negative print at the start of Q3. Moody’s warned in June that it could reconsider its UK rating if slower growth combines with weak fiscal consolidation. All in all, not very supportive of the view that UK is a better credit risk than Germany, and EUR/GBP should give up some of its gains when this view eventually reverses. Meanwhile, EUR/CHF continues to fall and while SNB actions are possible, there is simply nothing it can do about the currency when global safe haven flows are ongoing. Same goes for BOJ, with USD/JPY now giving up all intervention gains.

In this current environment, EM policy-makers will try to limit collateral damage from DM crisis by whatever means possible. A 3-month ban of short selling has been approved by the Korean Financial Services Commission while FX intervention risks in Korea will remain at very elevated levels, as BOK was reportedly in the market selling USD (along with the central banks of Taiwan and Indonesia). Elsewhere, China data out today is consistent with our soft landing scenario. The much awaited CPI did not bring much of a surprise at 6.5% y/y. Food prices were again the culprit, rising 14.8% y/y. This again suggests a more benign underlying trend as non-headline items are not accelerating. Other data from China today, including industrial production and fixed asset investments, came mostly close to expectations. Retail sales, however, disappointed a bit, rising 17.2% y/y vs. 17.7% expected but still a healthy pace. Given China’s strength, we still favor Asia FX to outperform in a slowing DM backdrop.