Dollar Softer Ahead of European Summit

BBH CurrencyView

• Dollar largely softer vs. majors as markets await outcome of the European summit today
• Signs point to a “bare minimum” response from European policy-makers; euro upside seems limited
• EM currencies mixed; TRY outperforming on apparent return to orthodoxy by Turkey’s central bank

Markets are basically sideway, awaiting more details from EU leaders. EUR/USD is holding above 1.39 while most other currencies are little changed against the dollar. USD/JPY is just below the 76 level as the MoF steps up its intervention rhetoric. AUD was the largest mover of the day, falling about 0.75% against the dollar after lower than expected core CPI numbers helped firm expectations for a cut by the RBA in next week’s meeting. In EM, TRY was the best performer as the central bank gave another strong signal of its newfound hawkishness. Global equity markets are mixed but S&P futures are pointing to a 0.5% higher open after closing sharply lower yesterday. In fixed income markets, yields are about 5 bp lower in France and 30 bp lower in Greece, while rising as much as 4 bp in Germany and the US. Oil is up again, rising for the fourth consecutive session with WTI future at $93.50 from a low of $75 earlier in the month. First 12-month tender in about two years saw ECB lending EUR56.9 bln, lower than Bloomberg consensus for EUR70 bln. Sterling is underperforming after weaker than expected CBR report for UK.

At most, an agreement in principle and some broad understandings are the most that should be expected from the summit. Further development is likely ahead of the G20 summit on November 3. The general outline at this juncture is for EFSF to act as insurer for new Italian and Spanish issuance, around EUR100 bln in European bank recapitalization by the middle of next year, and a special purpose vehicle set up that will hopefully see outside investors. The IMF may offer precautionary lines of credit to Italy and Spain. Deeper "voluntary" haircuts toward 50% or more on Greek exposure will be sought. The ECB’s independence will likely be preserved and will not be forced to be involved with the EFSF schemes. Before the summit, Germany’s parliament must first debate and vote on proposed changes to the EFSF. The summit will then reportedly begin at 6:00 PM local time (12 noon EST), to be followed by a working dinner and then official press conferences. How will markets trade on yet another “underwhelming” policy response? Euro remains firm, but upside seems limited given likelihood of ongoing euro zone uncertainty. There is widespread talk that European banks are selling off dollar assets and repatriating the funds. This reduces their dollar funding needs and reduces their balance sheets, and while it makes some sense, there doesn’t seem to be much evidence for it. Italy sold EUR10.5 bln in paper today to lukewarm reception, as bid to cover ratios fell and yields rose. Local Italian press is reporting that PM Berlusconi has made a promise to step down early next year in return for coalition partner Northern League supporting efforts at pension reform. This seems out of character for Berlusconi, who has been adamant about serving out his full term.

Australia inflation data for Q3 follows New Zealand’s lead, with lower price pressures likely to allow RBA to start easing soon. Headline CPI rose 3.6% y/y in Australia, right at consensus. However, trimmed mean inflation was much lower than expected at 2.3% y/y vs. consensus of 2.7% y/y and a downwardly revised Q2 gain of 2.6% y/y. Report comes just ahead of the RBA meeting November 1. Prior to the CPI data, consensus was for rates to be kept steady at 4.75% then but have now tilted to a 25 bp rate cut after the CPI data. Note that the OIS market is pricing in up to 125 bp of easing over the next 12 months. While some easing is likely, we think that 125 bp overstates the case for easing. Interestingly, New Zealand reported softer than expected Q3 inflation data too (4.6% y/y vs. 4.9% consensus and 5.3% actual in Q2) and yet the market is pricing in 25-50 bp of tightening by RBNZ over the next 12 months. This reflects expectations that the RBNZ will take back its emergency post-earthquake 50 bp rate cut, but this will depend on external developments too. RBNZ meets tonight, and is widely expected to keep rates steady at 2.5%.

In the EM space today, the Turkish lira is the standout after the central bank did not hold a regular 1-week repo auction, effectively forcing banks to borrow at the much higher overnight rate that it hiked last week. Governor Basci said that tightening has started, and the central bank also raised its inflation forecast for 2011 to 8.3% from 5.9%. We may finally be seeing the long-awaited return to orthodoxy in Turkey. While policy-maker credibility will take some time to restore, this is a much-needed first step and so for now, TRY is likely to play some catch-up when EM strengthens again. The bad news is that EM remains hostage to euro zone developments.