A Douse of Cold Water

BBH CurrencyView

• Risk sentiment remains under pressure overnight; global equities lower, dollar mostly higher
• European economic data continue to deteriorate; UK September inflation surges to new highs
• RBA minutes point to some capacity to lower policy rate; China’s GDP softer than expected

Market sentiment continues to deteriorate in part from the combination of soft equity earnings and comments from a German official suggesting that the October 23 ECOFIN summit will not provide a quick solution to the euro zone crisis. The negative tone carried into the Asia session, weighing on Asian stocks and currencies, with the MSCI’s Asian benchmark dropping more than 2.5%, while Japan’s Nikkei lost 1.5%. Elsewhere in Asia, China’s monthly data releases show domestic demand remains strong despite growth coming in at its slowest pace since 2009, with Industrial production, urban fixed-asset investment and nominal retail sales all slightly better than expected. Overnight, Moody’s said it may downgrade the outlook on France’s Aaa rating to Negative in the next three months depending on the extent to which its finances are stretched by the costs of bailing out euro zone members and banks. Against this backdrop, European stocks are under pressure for the second day in a row with banks shares leading losses in the EuroStoxx 600, down over 1.6%.

Today markets are likely to focus on the dwindling optimism surrounding the potential European plan and in turn a potential shift back to risk off or at the very least profit taking ahead of this week’s all-important Greek austerity vote and ECOFIN summit on Sunday. Indeed, the douse of cold water by German officials, who sought to limit the market’s expectations for this weekend’s summit, continues to be a blow to risk appetite and also appears to be undermining what had appeared by some observers to be promising developments. From here, it is likely that the EUR/USD remains under pressure with the 20dma (1.355) the next important level to be tested. What’s more, European economic data continues to add weight to sentiment as October’s decline in the German ZEW adds further support that Germany is being hit hard by slowing global growth and indeed the euro zone debt crisis. October’s reading was in fact the lowest reading since April last year, with the 3-month moving average dropping to -43.1 from 32 in the three months to September. Taken together, the results of the ZEW coupled with the fact that business surveys have fallen sharply appears to support the notion that German growth is beginning to falter, suggesting that it is becoming more likely than not the ECB have its hand forced and cut rates before 2012. Elsewhere, UK Sept. inflation surged to 5.2% y/y from 4.5% y/y in August, matching the post1991 high that was seen in September 2008. This might cast further doubt on the MPC’s assumption that weak growth and spare capacity will bring underlying inflation down yet higher inflation is a further blow to consumer spending power and highlights economic resistance of prices amid the current cycle. Nevertheless, these forces are certainly not a reason for the MPC to hold back from loose monetary policy in an attempt to support growth but in any event the policy response is negative for GBP.

In Asia the RBA meeting minutes appear to open the door for possible easing conditional upon deterioration in the global backdrop. Yet we continue to expect the RBA to remain on hold in Nov. and feel the easing bias priced into the market is too aggressive. According to the minutes of the October meeting, "Members believed that an improved inflation outlook, if confirmed by further data, would increase the scope for monetary policy to provide some support to demand, should that prove necessary." The lack of change to rates was supported by an apparent improvement in the inflation outlook (conditional on upcoming data), some easing in financial conditions and a decline in the exchange rate from high levels a few months ago. The minutes concluded by saying "That steady policy would be reviewed based on developments in global financial markets and on further data on economic activity and prices ahead of the Board’s next meeting." Elsewhere, markets were weighed down by the slightly lower-than-expected GDP number out of China. We don’t think this is reason for concern and we are inclined to fade the move. In fact, we think this is a medium-term positive development in many ways. First, the data is consistent with the slightly lower bank lending numbers out earlier this week, which re-affirms that China is decelerating towards a soft landing. Second, this moves us closer to the point when policymakers will be ready to relax tightening measures. We don’t think that China is there yet, but we are closer to easing than most observers expect, in our view. Policymakers will take no risks on growth and employment, especially with so many external risks and rising internal political/social tensions. In terms of CNY, we maintain our view that the appreciation will resume soon and will continue around a 3-4% annualize rate for the time being.