Operation Twist Brings No One to the Dance Floor

BBH CurrencyView

• USD continues to surge amid safe haven demand; EUR breaks below 1.35, EM currencies drop 1-2.5%
• The Fed delivered “Operation Twist” but bleak economic outlook continues to weigh on sentiment
• Czech CB remains put, South African CB expected to do the same; Brazil unemployment and inflation

The Fed’s announcement failed to turn around market sentiment and the overnight rout in Asian equity markets gathered speed in Europe amid more signs of a global growth slowdown from the Chinese and European PMIs. The Nikkei and Hang Seng fell 2.1% and 4.9% which has been followed by morning losses of 3.5-4.1% in the European benchmark losses with financials and materials leading the way down. US equity futures point to a sharply weaker open: -191 for the Dow Dec11 and -22 for the S&P 500. In government bonds, the risk rout in equity, commodity and credit markets has reinforced the bullish flattening direction dictated by the FOMC announcement, sending US 10yr and 30yr yields to new record lows, down 5bps at 1.81% and 9bps at 2.90% respectively. Euro zone peripheral government bond spreads against Germany are trading at new highs for the week, with Italy’s 10yr spread at 398bps (+2bps), Ireland at 667bps (+14bps), Portugal at 932bps (+9bps), while Spain is up 1bp at 361bps. Commodities are sharply weaker with crude down 3.5% and copper -5.2%.

The Fed provided the much anticipated “Operation Twist”, with a twist on the twist to try and boost the mortgage market, but the market reaction continues to be disturbing. Admittedly, in terms of stimulus the Fed is likely to have provided more than the market was anticipating, with the twist involving more than $400bln of duration swaps along the yield curve for a period of roughly nine month and more surprisingly a move to reinvest principal payments from its holding of agency debt and MBS in MBS, rather than USTs. The disappointment that is likely adding to further market strain this morning is the fact that the Fed now sees “significant downside economic risks” which is leading to a sharp drop in commodities, stocks and a rise in the dollar and a broad re-pricing of global asset prices to reflect the continued global slowdown. Ultimately, the major concern for markets at this juncture is with the Fed having offered the market more accommodative policy, all we have to forward to is the situation in Europe and hopefully a turn in the macro data. This market response in part highlights the limitation of monetary policy amid the backdrop of austerity and budget tightening against a global slowdown and indeed looking ahead there is likely to be a stronger push for easier fiscal policy. What’s more, the combination of weak PMIs from China (last night) and Europe (this morning) continue to paint a picture of weaker global growth in the coming months. In fact, the Euro zone composite reading below 50 suggests the region is on the verge of recession. For the FX markets, even with the Fed going a bit further than some had hoped there is a feeling that going forward the Fed is now going to be relatively less dovish than the BoE (which is gearing up for its own round of QE) and the ECB (which may be forced to cut rates itself and on a weekly basis continues to expand its balance sheet). Altogether, these expected policy shifts and the sharp drop in risk appetite are likely to keep the dollar bid.

In the EM space today markets are likely to focus on the South African central bank (SARB) policy meeting and Brazilian unemployment and wage figures. We and the market expect the SARB to remain on hold at 5.5%, given sharp deterioration in global market sentiment since the July meeting. What’s more, the SARB is likely to point to the sharp drop in ZAR as the major catalyst for the potential rise in inflation, if it moves higher from here. According to the BIS’s trade weighted ZAR index, for example, the currency has declined by nearly 10% since its recent peak in December. External risks notwithstanding, August CPI was just released this week, with both y/y rates for headline and core remaining steady at 5.3% and 4.3%, respectively. That means, domestically there are fundamental signs that price pressure are fading (with domestic demand turning sluggish as well) which is likely to ease some of the pressure off of the SARB for now as it seems wholly unprepared to hike rates in response to headline inflation breaking above the 3-6% target. Taken together, while higher inflation is still a risk, especially with ZAR weakening so much and feeding into imported price pressures, we suspect that slow growth and unemployment near 25% a rate cut is the next move. In Brazil, the market consensus is for unemployment rate to inch higher to 6.1% but real wage growth is expected to remain firm at 3% y/y. Regardless, an unemployment rate this high is still near the lows for the cycle and coupled with the rise in wages underscores the heightened inflation risks as wage pressures rise. Market continues to price in 125-150bps of rate cuts by year-end, which is still way to aggressive given the inflation risks. EM expected to remain under pressure amid risk aversion.