Grant Greece Default, Just Not Yet

BBH CurrencyView

• Market cautiously optimistic amid hopes of China bond purchases and Merkel, Sarkozy conference
• Moody’s downgrades two French banks; EUR resilient off the back of potential policy response
• Brazilian retail sales stronger than expected; Russia’s central bank surprises with a 25bps rate cut

European equities reversed earlier losses after more supportive comments from EU politicians appeared to deflect the risk of a disorderly Greece default. Following the Franco-German conference call on Greece, French President Sarkozy’s statement that France will do everything to save Greece lent support to market sentiment. At the same time, finance ministers from Brazil, Russia, India and China are planning a meeting on September 22 to discuss capital involvement in the euro area, which appears to have mitigated somewhat the headwind effects of Chinese PM Wen’s denial of EU bailouts overnight. The EuroStoxx 50 is up 1.7%, reflecting broad-based gains with financials gaining 1.3%, although performance remains mixed following the downgrade of two French banks by Moody’s. EZ peripheral bond spreads are tighter with the exception of Greece. Nevertheless sentiment remains mixed and commodities are on the defensive this morning, with oil and copper down while gold is firmer on continued global growth/financial systemic fears. US futures point to modest open.

The focus for FX markets today is most likely the outcome of the telephone meeting between Merkel, Sarkozy and Papandreou, with markets hoping that crisis can be averted. After all, the euro’s recent sharp drop appears to have generated additional demand for euros from reserve managers. However, follow through participation from private managers is likely to remain thin even though risk reversals suggests that positions are becoming saturated after the sharp extension of euro shorts in the past two weeks. Indeed, according to the most recent weely speculative CFTC positioning data, euro exposure has been cut by over $6bln, leading to nearly a 2 standard deviation drop in the dollar value of CFTC euro exposure. Technical studies suggest that 1.3500 is the base for now, with the French bank news, Chinese PM Wen’s comments and the banking crisis all in. What’s more, that while the market is looking for a policy response from Merkel, Sarkozy and Papandreou that limits the potential of an imminent disorderly Greece default, the outlook for the euro remains negative. The risk of a hard Greek default remains high but for now the Merkel, Barroso comments suggest Europe can garner enough political not to unleash financial Armageddon. That said, price action set to remain choppy and the market’s sensitivity to headlines remains high. In the UK, despite the better than expected headline data, today’s employment report provides further evidence that fiscal consolation in the UK continues to sap labor market growth. For one, employment fell by 69k in the three months to July, the first fall this year. Next, the ILO measure of unemployment rose by 80k over the same period (the largest rise in nearly two years) and the despite the upside surprise in the claimant count measure, unemployment claims still rose by over 20k in August. Renewed stress in the global financial system and external shocks are likely to add to already weak domestic demand growth, which in turn is likely to bolster the case for the doves at the MPC.

Brazilian July retail sales came in stronger than expected, up 7.1% y/y, outstripping the market consensus by 0.6%. The m/m May figures were also revised higher by 0.1% to 0.3%. Taken together, the figure was a good start for Q3 data, with the healthy gains in furniture and appliances leading the way. Notwithstanding some signs of weakness in some of the supply side measure, demand appears likely to expand at a reasonably good pace driven by strong consumer confidence, favorable credit conditions and supportive job growth, which looking ahead is likely to remain supportive of the Brazilian economy. Near-term, though, economic contagion from DM continues to remain one of the key downside risks. Meanwhile, weekly central bank survey showed more deterioration in inflation expectations, as well as a year-end SELIC rate of 11%. This implies 50 bp cuts each at October 18/19 and November 29/30 meetings, which is also the most likely path implied from the OIS market. Indeed, Brazilian OIS rates current imply a 72% chance of a move to 11.50% in October. To us, that seems like the likely path since August cut was certainly not a "one and done." Some observers might suggest that a move this aggressive is a mistake, but it looks like they are ready to double down on this one. Price action the last couple of days shows that the one-sided positioning in BRL leaves it open to violent moves. In Russia, the central bank surprises markets with a rate but in our view not the beginning of new cutting cycle. On balance, barring a sharp drop in credit conditions or economic growth, we continue to expect that the central bank is likely on hold.