Market Sentiment Remains Cautiously Optmistic

BBH CurrencyView

• Market sentiment continue to improve modestly; European stocks and US futures both advance
• Finland ratifies changes to EFSF, Germany votes tomorrow; EUR/USD trades just ahead of 1.37
• EM price action of IDR & KRW reinforces themes; Hungary unemployment rate, Mexico GDP in focus

Market sentiment continues to improve, albeit modestly, as investors continue to remain somewhat optimistic that European policy makers are making headway towards mitigating the crisis. As a result, the EUR/USD traded at session highs, near 1.37, which coincided with European stocks reversing earlier losses and moving into positive territory. The EuroStoxx 600 is hanging on marginal gains, up 0.2%, with bank shares weighing on the index, down 0.5%. Asian stocks closed a touch higher, but trading was largely subdued overall. The MSCI Asia Pacific Index was up just 0.5%, while Japan’s Nikkei gained 0.15% by the Tokyo close. Yesterday’s rally was influenced by both quarter-end window dressing and hope that European policy makers finally understand both the severity and the urgency of the situation it is facing. Elsewhere, the BoE’s Miles is the latest MPC member to talk up the possibility of QE2 in the UK, which appears increasingly likely in Oct or Nov.

The euro zone, again, continues to occupy center stage. The noises out of Europe suggest that bank recapitalization and an enhanced EFSF is on the table, but the finer details are yet to be agreed and rhetoric in the last session or two highlights the difficult political process in getting all 17 euro members to agree to one plan. In fact, yesterday’s rally was interrupted by a news report suggesting that 7 of the 17 EZ members would like more private sector involvement in the Greek bailout. And while this morning Finland’s parliament ratified the expanded powers of the EFSF agreed in July, Finland’s demand for collateral in exchange for its share of any loans to the EFSF is unlikely to be fully addressed at this juncture. Indeed, the Finnish Finance Minister, Jutta Urpilainen, has argued that the EFSF should be ratified before the collateral deal is ironed out, arguing that “the EFSF is a tool. Finland’s collateral demand relates to the use of that tool, not the mechanism itself”. After Finland, seven other EZ parliaments will still have to ratify the changes to the EFSF, including Germany tomorrow. Nevertheless, the EUR/USD remains quite resilient and with the possibility for continued positive news flow (including the potential ratification of the EFSF by Germany and the announcement of the Troika’s aid transfer to Greece) we think it is likely that the EUR/USD could test the upper end of its recent range, between 1.380 – 1.40 in the coming days ahead of the ECB. The rub is that one single failure in this sequence is likely to be catastrophic, which attests to the non linearity of the potential outcomes the EZ is facing. What’s more, the potential for firm German and inflation figures (along with the higher M3) suggests to us that the case for a 50bps rate cut by the ECB next week is overstated. Still, some observers think that additional liquidity provisions are more likely but we would also not rule out a 25bps rate cut, leading to a consolidation in the EUR/USD rally.

In the EM space the past few days of price action has reinforced many of the themes we have been discussing, especially given the outperformance of IDR and KRW in the region. In Asia, we think that the balance of risk starts to shift when USD/IDR approaches 8900 and USD/KRW approaches 1200. IDR and KRW will be supported by relatively more aggressive official intervention during periods risk-off and will likely benefit from stronger rebounds during periods of risk-on. A similar logic applies to USD/SGD around the 1.29-30 level, around were we see an excellent level to get short USD. Also note that data out of Singapore remains on the strong side, in line with our view that the MAS will continue to appreciate the REER SGD – albeit at a slower pace. In relative terms, India’s twin deficits relegate INR to our short currency of choice until we get a sustained recovery in global equity markets. In CEE, Hungary’s unemployment remained at 10.8% in August, in line with consensus. Overall, the figure has remained flat over the previous 3-months which has seen activity remain steady at 56% – the highest figure seen in the past 10 years. In fact, in spite of the intensification of the euro zone debt crisis and weak domestic backdrop, Hungary managed to create 32k more jobs than a year ago. Taken together, strong rise in the activity rate keeps the labor market loose, a net benefit for employers and the inflation backdrop, although this reflects lost earning capacities of households. In the North American session, Mexico releases its months GDP proxy for the month of July, with the market consensus expecting a rise of 3.65%. Notwithstanding economic performance, which is showing signs of a slowdown price action today is likely to be dominated by a potential Greek solution. We prefer new longs below 13.30.