New Week, Same Drivers: renewed weakness in financials and Greek default concerns

BBH CurrencyView

• European stocks snap a four-day amid Greek default concerns; EUR/USD gapped lower near 1.363
• Markets this week are likely to be dominated by political risks in Europe, along with FOMC meeting
• In the EM space, central banks from Czech Republic, Hungary, South Africa, and Turkey all meet

European equities have interrupted a four-day rebound to trade sharply lower at the start of the week on renewed weakness in financials and Greek default concerns. The Dax and the CAC40 are down 2.7% and 2.5% respectively with French banks taking the brunt of the pressure down 3%, taking over from a weak overnight session in Asia (Hang Seng -2.4%; Kospi -1%). This is driving 3-digit losses in benchmark US equity futures with the Dow Dec11 contract down 142. Weaker European equities underpin fresh flows into core government bonds following last week’s correction from record high levels. US 10yr yields are down 8bps, falling back below the 2.0% psychological mark, with investor expectations ahead of this week’s FOMC decision probably also playing into capital reflows.

This week markets are likely to remain focused on Greece, with fears that Greece will likely run out of money in the next few weeks unless the next tranche of aid from the Troika is disbursed a major concern. And while the IMF has recently commented that additional efforts are needed to cut the Greek deficit, the IMF’s Traa suggested at a conference today that the IMF disagreed with the view that the program carried out by the government has been unsuccessful to date and that "impressive fiscal consolidation has happened.” Ultimately, we continue to expect that Greece is likely to undertake the necessary steps to secure the next aid tranche and in turn confirmation of that release is likely to see the EUR consolidate some of its recent losses. Yet, we expect that the combination of continued euro zone financial stress as European policy makers continue to fail to get ahead of the crisis and the potential for the euro zone to slip back into recession as strong headwinds for a sustained EUR/USD rally. In fact, this week the focus in Europe will also be on data, with many observers expecting a sub-50 EZ flash PMI on Thursday, the first since July 2009. At the same time, the Finnish debate over the ratification of the EFSF (which begins on 9/21) is expected to provide headline risk for the EUR/USD as well. Thus, we continue to expect the EUR/USD to chop around the 1.35 – 1.40 range. Admittedly, it is hard to look past the events in Europe this week but markets are also likely to focus on this week’s FOMC meeting, BoE Minutes, Norges Bank, Canadian inflation and Swiss money supply growth. We head into this week’s extended FOMC meeting with expectations of a policy response to support a struggling economy and boost financial market sentiment. Some observers suggest that the Fed is likely to announce “Operation Twist” in which the Fed extends the duration of it current holdings, buying longer-date securities in exchange for securities with shorter-maturities. As a result, the “stock” of balance sheet assets is likely to remain unchanged and thus a policy decision in line with “Operation Twist” is expected to be less negative for the dollar than other actions. Many expect the BoE MPC minutes to show growing support for further QE, with this week’s minutes likely to showing a change in voting preference for further QE.

In the EM space, central banks from Czech Republic, Hungary, South Africa, and Turkey all meet this week. We don’t see any change from these four central banks and in general we believe EM central banks have moved into dovish wait-and-see mode for now, with the obvious exception of Brazil and Turkey, who have both cut, and RBI, who just hiked 25 bp for purely domestic reasons. At some point, more EM central banks are likely to cut if the global outlook worsens, but we think it is prudent and likely, that most remain on hold for now. Markets are, however, punishing the countries that have cut rates with an eye towards a weaker currency, Brazil and Turkey. We remain defensive on EM in general due to the deteriorating global environment, but much of EM FX should hold up ok since EM fundamentals remain better than DM fundamentals. EMEA remains the weak link in EM, and so many of the currencies are likely to underperform due to some combination of big fiscal and current account deficits and inflation. Elsewhere this week, markets are also likely to monitor inflation in Malaysia and Singapore for signs of a trend change. In Malaysia, markets will be looking for signs that inflation peaked, with headline inflation expected to slow to 3.3% y/y in August from 3.4% y/y in July. The a peak in inflation would likely mean the Malaysian central is more likely to be more concerned with external risks, which against the current risk backdrop may lead to less of an appreciation bias. In Singapore inflation is expected to moderate but strong domestic demand points to inflation remaining above 5% for the time being and likely to maintain marginal SGD strength.