A Glimmer of Hope

BBH CurrencyView

• European stocks rally for a fourth day ahead of outcome from ECOFIN meeting; US futures tread lower
• Coordinated policy action good step; further support for EFSF/Greece needed to hold momentum
• CNY continues to be used by Beijing as a tool for managing inflation; NDFs imply further strength

European markets extended this week’s rally (up for the fourth straight day) with the DAX returning back to levels not seen since the start of the month near 5600, at 5560 last (up 1%) as investors await the outcome of the ongoing ECOFIN meeting. US equity future, however, are treading weaker ahead of today’s consumer confidence report, while the dip in the Dec11 S&P contract back below 1200 to 1197 points to a more balanced backdrop now that fears of European bank default have subsided. Core government bonds are steady following yesterday’s sharp negative correction, while the markets continue to reprise EZ contagion risks. Greek 10yr yields are down 144bps, Spanish and Italian 10yr yields are down 10bps and 17bps, while Belgian and Portuguese yields are down 15bps and 9bps. German 10yr yields are little changed from the close at 1.93%, US 10yr yields hold at 2.08%. Commodities are mixed with industrials trading higher, while gold and oil are marginally weaker.

Market sentiment continues to improve in part from coordinated global policy action on behalf of central banks. And while this move is unlikely to prevent a Lehman-style event since it is more likely than not that the market is coming to grips with the fact that Greece is insolvent, it does bolster market confidence in policy maker’s ability to take bold action to stave off a crisis. Some observers would suggest that this most recent crisis is rooted in a lack of political will and confidence in policy makers, rather than just pure economics. To us, this recent step by policy makers to act decisively is a positive sign for markets in the near-term, showing that policy makers are aware of the interconnectedness of the global economy. In turn a coordinated global response does in some part help solve the problem of a global financial system that continues to be driven by regional issues. Taken together, these actions are likely to bring much needed relief to the markets but this is no silver bullet and equally important unlikely to be the last of the European sovereign debt crisis. Nevertheless, the conditions for a short-covering rally in the EUR and other growth sensitive currencies appear to be gaining momentum. An upside break of the 200dma would likely lead the EUR to retest levels between 1.415 -1.43. Looking ahead, while market action is likely to a bit more quiet ahead of the weekend, investors are expected to be looking for further support of Greece at this weekend’s ECOFIN meeting. The focal point of the meeting will be the EFSF and also talks over the conditionality that countries like Finland and Holland are demanding for approval of the facility. We suspect that any major announcements are unlikely but would not rule of the possibility of a resolution over the Finland’s request for collateral in the second Greek aid package. Any progress on Greece is likely to boost risk appetite and in turn would likely lead the dollar to pare back some of its recent gains. Based on recent correlation patterns a jump in the S&P would likely boost the AUD, CAD and NZD the most, while the SEK and NOK have become more sensitive to European bank shares.

In EMs, China’s CNY was allowed to push higher versus the USD, at a mid-point of 6.379. That’s the highest level for the yuan since the resumption of a managed float in June 2010 and since official and market FX rates were merged at the end of 1993. Beijing is guiding the CNY gradually higher as one of a series of measures to contain domestic inflationary pressures and tighten financial conditions. Remember, in a world of global capital flows macro economic theory suggests that policy will need to be a balance of a fixed (or managed) exchange rates, free capital movements and independent monetary policy. What’s more, the analytical framework suggests that it is impossible to have all three at once so in turn it appears that China is using some combination of all three to manage its financial conditions. CPI was 6.2% y/y in August and as a result Chinese policymakers are eager to see further disinflation. Last month the CNY saw its biggest monthly gain year to date thus far, as part of what many observers expect will be a stepped-up pace of CNY appreciation, perhaps a 6.5-7.0% annual pace. Currently, NDFs imply a further 1% appreciation over the next year. The weakening of the US economy and global market turmoil is a worrying sign for Chinese authorities as it may increase the odds of excess liquidity, which could further raise China’s inflationary pressures through higher food and energy prices. China’s high inflation relative to the US and elsewhere means that the real CNY exchange rate has already been appreciating much quicker than the nominal value (15% faster since 2006, using BIS data ), but nominal appreciation should in time slow domestic inflation.