Markets Cautious Amid Hopes for the Policy Bazooka

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• G20 Finance Ministers said they expect decisive action on 10/23; dollar pares back some recent losses
• Markets likely to remain focused on Europe this week with Greek austerity vote and EU summit
• EM markets this week focus on rate decisions in Brazil, Turkey and Philippines; South Africa CPI

The dollar has pared back some of its recent losses in part after Germany weighed expectations for a grand solution on the euro zone crisis at this weekend’s EU summit. Nevertheless, the G20 Finance Ministers said they expect this weekend’s EU summit to “decisively address the current challenges through a comprehensive plan, which continues to support stocks and commodities with crude oil near $87bbl. Asian stocks rallied sharply (with the MSCI Asia Pacific index up 2%) after benefiting from Friday’s encouraging US data and ongoing optimism over potential rescue plans from Europe, even though the G20 leaders remain short on details of the “bazooka” plan. European stocks remain bid, extending their longest rally since April with the EuroStoxx 600 advancing 0.4%. Shares are led by the nearly 2% rally in oil and gas with banks sharing tracking moves in the broader index. Against this backdrop, 10-year peripheral yields are mostly lower while bunds and gilts are mixed.

Following this weekend’s G20 summit where policy makers discussed potential solutions for 1) the extend of Greek haircuts, 2) details of a European bank recapitalization an 3) increasing the firepower of the EFSF suggests that the key event this week is likely to be the EU summit on Sunday. Indeed, markets are hoping for the “big bazooka” that is finally used to find a solution for both of the euro zone’s ills, including both sovereign debt and banking crisis. To gauge the potential market reaction it is could be useful to the looking market positioning data, which recently reported on a small reduction in USD longs. As a result, a bold policy response that addresses the three key issues listed above could support an extension of the recent risk rally, especially given the speculative community is still long roughly $11bln (down from nearly $15bln the prior week) against the dollar, according 8 currencies positions tracked by the CFTC. That means, without additional bad news from either the political or macro front, an extension of the short squeeze in risky assets and unwinding of long dollars is expected to occur (although the Greek austerity vote on 10/20 some important headline risk, given its binary risks to the downside of the EUR/USD). From here, the euro could trade between 1.37 and 1.39, with strong downside risks if the austerity vote is not passed. In the US, this week, there is not a huge amount of macro data, but we do get the first glimpse of October reports on Thursday and Friday. US earnings season will also be in focus, and expected to impact market sentiment, given there are over 100 majors S&P companies reporting this week. In the UK, there is expected to be some focus on UK data as well, with inflation and the latest MPC minutes expected to shed some light on the recent BoE QE decisions. In the dollar bloc, Canadian inflation and RBA policy signals from the RBA minutes are likely to be watched for a shift in rate expectations. Elsewhere, this week the Norges Bank is widely expected to remain on hold at Wednesday’s meeting.

Just in case you thought that something has really changed, Brazil’s FM Mantega was quoted in a German newspaper after the G20 summit saying that the “currency war” is still going on. We are not so sure. Beyond broad risk appetite, a less dovish BACEN could be the catalyst for a faster recovery of BRL, possibly outperforming other EM currencies. The 50-day MA at around the key 1.70 level will be the first major test for USD/BRL. After that we begin to revisit the old “lines in the sand” where policymakers tried to hold the currency pair in the past, starting with the 1.65 level which held until late March 2011. On Wednesday the Brazilian central bank announces is rate decision. The market is currently pricing in nearly 100bps of cuts still this year and another 50bps for next year. We think this is excessive. Markets have jumped on receiving short-dated rates in Brazil since the CB’s surprise cut in August. More cuts are likely this year, but with data in the US surprising the upside, the real much weaker, and inflation expectations elevated, the bank may show some restrain. We agree that a 50bps cut on Wednesday is the most likely outcome, but we think that the chances of a 25bps cut or of less dovish language are higher than the market is expecting. This week we also have interest rate decision by the Philippine and Turkish central banks. We expect no change in both cases. FX remains the main focus in Turkey with the central bank reopening its USD selling auction today, albeit in a small size. In terms of data, tomorrow we get a lot of data from China, including retail sales, industrial production and Q3 GDP out of China with the market expecting a small deceleration from 9.5% to 9.3% yoy. On Wednesday we have CPI and retail sales out of South Africa.