The United States of Eurasia?

BBH CurrencyView

• The dollar remains supported in choppy markets; French banks under pressure amid funding concerns
• Euro zone risk premium continues to widen; Greece dances with default, tepid Italian bond auction
• Banco de Mexico is likely to cut by at least 25bps in October; macroeconomic asymmetries in EMs

Global trading remains volatile amid ongoing fears. European equities lost opening gains as initial hopes that China’s official visit to Rome may result in increased Italian bond purchases lost traction given uncertainty about the size of China’s eventual involvement. A US advisory has indicated that the CIC cannot invest further in Italian paper without expanding its quota which would need new cash from SAFE and a mandate to buy more Italian paper. A WSJ report citing an unnamed source who suggested that BNP can no longer fund itself in USD markets further aggravated fears, though it was later denied by the bank. Nevertheless French banks remain down 4.3% on the day, led by BNP (-7.2%) and another disappointing Italian action hurt market confidence further. German 10yr yields remain near record lows at 1.739%, with USTs bid 1t 1.944% for the 10yr benchmark yield on persistent haven demand. Italian 10yr yields are up 15bps to 5.692% while Italian 5yr CDSs are up at a new record high near 516. Commodity prices are mixed, with crude oil up nearly 1% and copper flat.

Concerns over the European banking sector continue to intensify, taking its toll European bank shares and of course the euro. What’s more, the combination of an increasing probability of a Greek default, a tepid Italian bond auction and the diminishing prospects of a Chinese rescue of the Italian bond market are a toxic mix for market sentiment. As a result, the variables that we use to gauge euro risk sensitivity continue to reach new extremes. The benchmark 5-year Italian CDS, for instance, widened by 12bps today to 515bps (a new record high), which implies roughly a 73% chance of a 20% haircut using a standard credit model to imply the odds. Spain’s 5-year implies a 68% chance of a 20% haircut. Indeed, Italy’s 5-year odds of a 20% haircut have increased by nearly 40% in just two months and again highlight the increasing intensity of the stresses manifesting in the European banking system. In the same way, today’s Italian bond auction highlights the difficult conditions in the EZ, with refinancing costs much higher and a lower bid-to-cover ratio. Arguably, the source of this stress is unlikely to dissipate anytime soon, with Spain and Italy both coming to the bond market in the coming days to test the market’s appetite for EZ debt. In the same way, funding costs continue to remain elevated in spite of the recent announcements of new fiscal austerity measures in Spain, Italy and even Greece, which enacted measures over the weekend in an attempt to shore up the next tranche of funds from the Troika. In fact, the European equivalent of the TED spread (which captures the perceived credit risk in the domestic economy) continues to widen exponentially, up to 83bps today from 20bps in June, even though it still have quite a long ways to go to reach levels seen in 2008. That means, global stress this time around is linked to the EZ, not the US, and looking ahead the euro’s performance is in some part linked to the funding and liquidity needs of European banks.

In the EM space the USD/MXN made new highs yesterday but stopped just short of resistance at 13.00 off the back of broader risk aversion. Market is pricing in a cut by Banco de Mexico at next meeting in October, with the OIS market pricing in nearly a 57% chance of a 50bps cut in the policy rate. That means, a rate cut of sorts is all but inevitable. We think that’s too early, but stranger things have happened and all told it appears based on the OIS pricing that the most likely outcome for the policy rate is nearly a 75bps drop from current levels over the next six months. We think the OIS curve is pricing in the worst-case at this juncture and in our view would expect the policy rate to be lowered at a more gradual pace. On balance, we expect the Banco de Mexico to cut at the next policy meeting but we suspect 50bps is too aggressive and would expect the bank to follow up with another 25bps cut at the Dec. meeting if the global situation worsens. Bank Indonesia reportedly sold USD Monday to help limit IDR losses. Most in EM fall in this camp. That is, they accepted a strong currency begrudgingly and they do not want a weaker currency now that sentiment has shifted. In a sense these are macroeconomic asymmetries that arise between developed and developing economies, with EMs following pro-cyclical policies in times of market stress, leading EMs to “self insure” themselves when times are good with excess reserve accumulation. But this has implications for EUR, as we pointed out last time EM came under pressure. Basically, EM reserve managers are now selling USD, not buying, and so that whole EUR bid from diversification is going to dry up. Add in SNB offers in EUR and one can make a case for a weaker euro ahead, even from an EM perspective.