Markets Remain Cautiously Optimistic Ahead of Tomorrow’s Summit

BBH CurrencyView

• European stocks edge to a two-month high ahead of tomorrow’s summit; USD mostly softer ahead of open
• There is still room for the EZ policy makers to disappoint tomorrow; S&P 500 approaching 200dma
• BoC likely to remain on hold but acknowledge improved growth outlook; RBI raised rates by 25bps

The European market remains quiet ahead of Wednesday’s EU summit, though risk appetite held up amid hopes that there will be a comprehensive solution on the euro zone debt crisis tomorrow. The dollar consolidated towards Monday’s multi-week lows, though EUR/USD movement was restrained around 1.3950 amid heavy option related offers, while sterling is stalling out near 1.60. Global stocks were for the most part stable with Asian and European shares boosted in part from better than expected earnings and hopes of a comprehensive plan at the euro zone summit. New Zealand CPI rose in Q3 driven in part by higher food prices but overall the report showed that inflation has slowed since peaking in Q2, supporting views that RBNZ is likely to remain on hold. Elsewhere, other news were mixed with unexpectedly strong German and French consumer confidence data offset by weaker than expected revenues from STMicro, whose shares consequently fell over 7% in Milan. Italian sovereign bonds continue to remain under pressure after Berlusconi failed to convince the cabinet of the need for further reform measures yesterday.

The focus for markets remains very much in Europe ahead of tomorrow’s Summit. There is still room for disappointment if euro zone leaders fail to deliver the solution that many are expecting. Despite the recent rise in the euro, which some observers would suggest is dominated more by hope than news and stretched positioning, euro zone specific indicators continue to price in a subdued outcome. For one, periphery CDS prices continue to increase, with Spain’s 5-year up over 20bps this morning, along with the continued rise of other euro zone country yields over Germany. Italy and Spanish 10-year yields continue in fact to increase relative to Germany, while France’s spread which has moderated a bit in the past few days remains high relative to its historical average. Nevertheless, we suspect that the euro (along with other risk sensitive currencies) have benefited from the broader rally in risk appetite amid the rise in stocks but it does not mean that the outcome of the summit is going to cure all the euro zone’s problems. We expect it may provide enough support in the short-term to support the euro amid its continued short covering rally but again the Summit is likely to fall short on medium-term growth drivers that would boost the economy. As a result, despite the potential for the euro zone risk premium to decline we expect the euro to remain under pressure as the economy continues to contract, forcing the ECB to cut rates before yearend and reducing the relative interest rate spread between Germany and the US. In the short-term we also expect risk sensitive currencies to run out of steam in the coming days as the S&P 500 approaches its 200dma.

In the day ahead we expect the BoC to leave rates unchanged, keeping the policy rate at 1.0%. At the same time while we expect rates to hold steady, we expect the BoC to acknowledge the likelihood of an improved growth outlook in the second half of the year off the back of improvement in the US economy and domestic strength in Canada. In our view, despite the potential for an improved growth outlook and the potential for upside risks to the economy, the BoC should remain on hold for quite some time. We continue to expect that CAD is likely to remain supported from the better than expected outlook for the US economy and thus the improvement in risk appetite but also expect tomorrow’s monetary policy report to be a key guide to the outlook for BoC policy. Indeed, the inflation outlook should be similar to recent reports, when the Bank said total CPI is expected to moderate in spite of the recent upside surprise in inflation that may prove temporary. From here, we expect CAD to respond positively to news from Europe but expect resistance near the 200dma.

In the EM space today the RBI raised rates by 25 bp to 8.5% and was the 13th rate move since early 2010, but it said it was likely to hold off on further increases as it expects high inflation to ease from December. It revised down its growth forecast for the fiscal year ending in March to 7.6% from 8%, while sticking with its forecast that headline wholesale price index inflation will ease to 7% at the end of the fiscal year, though it remains above the 9% level currently. The day ahead will feature CPI in Brazil with the market expecting the weekly FIPE print to increase to 0.34% from 0.32%. However, some yearend market forecasts see inflation falling amid a slowdown in economic activity. In fact, some market estimates for yearend 2011 and 2012 GDP were cut from 3.42% to 3.3% and down to 3.51% from 3.6%. That means, the economic trend moving forward is likely to be higher inflation and a moderation in growth with the central bank maintaining an easing bias. Put differently, some observers would suggest the market is beginning to accept that the BCB is likely to continue to ease policy in spite the stubbornly high level of inflation, which is expected to remain above the Bank’s target until the end of 2012. From here, further BRL upside is likely amid near-term outlook for EZ.