Risk Rally Fades Ahead of Key Technical Levels

BBH CurrencyView

• Dollar moves broadly higher after risk rally ran out of steam; European stocks slide from 2-month high
• Extreme market positioning, technicals and positive macro data enabled unwind of safe haven bets
• South Korea’s central banks keeps rates steady, China’s exports slow; Mexico likely to cut rates tomorrow

The dollar moved broadly higher after paring back some of its recent losses after the recent risk rally ran out of steam ahead of key technical levels. Asian stocks follow the trend put in place on the Wall Street, rising for a sixth day amid hopes that European leaders are inching closer towards a plan to tame the sovereign debt crisis, while shrugging off Chinese data that showed a modest pullback in China’s export growth. In fact, the MSCI Asia Pacific index surged 1.2% but gains were unable to be sustained in the European session after stocks fell back from a 2-month high. Nevertheless, the pullback in the VIX to 30 from levels near 50 in August underpin the improved tone and just released above forecast bank earnings is boosting S&P futures ahead of the open. Periphery yields are higher following the combination of a lukewarm Italy bond auction and ahead of today’s Italian cabinet meeting, which may lead to a vote of confidence later in the week. Meanwhile, an unexpected revision higher in German September HICP inflation may dent hopes of an imminent ECB rate cut. Oil prices down nearly 2.0%.

The dollar’s broad-based losses appears to have reached a natural pause after the recent short-covering rally ran its course and currencies, equities and bonds ran up against key resistance levels. In fact, as of yesterday nearly all G10 currencies, along with the S&P 500, having retraced almost exactly 50% of the decline from early September appear to have run out of steam for the moment. We suspect that the recent risk rally was based in part on extreme market positioning due to the extreme pessimism that was built into market’s psychology over the past few months. For one, the fears of a US double dip lacked justification in the real data and the extreme pessimism witnessed in the survey data was more likely fear from the recent string of global news. Equally important, US ISM indices remain above 50 and appear to have stabilized, jobless claims are holding steady, retail data this week is likely to be solid and US payrolls are showing moderate, albeit slow, growth. As a result, broad-based measures of market stress appear to be consolidating amid the combination of the consolidation of macro data and the move towards a bold response from European policy makers. Indeed, US Financial Conditions (measured by Bloomberg’s BFCIUS index) have improved by roughly one standard deviation since bottoming out in late September, 3-month EUR/USD basis swaps have narrowed by 21bps, while the IMF’s gauge of euro zone stress has fallen by 13%. That means, for the market to maintain this reversal we need to receive further confirmation that the macro data remains on track, financial conditions continue to improve and banking sector stress conditions to mitigate. Australia’s employment data last night (20.4k increase in employment) supports the improvement in the macro data but it is important to keep in mind that while European policy makers appear to have a better political understanding of the gravity of the crisis, concrete action to shore up the financial system has yet to be taken. That means the EUR/USD is best sold into rallies between 1.384-1.400.

In the Asia EM space South Korea’s central bank held rates steady, leaving the 7-day repurchase agreement rate at 3.25% to match expectations.This marks the fourth consecutive month that the BoK has held rates steady and led to the KRW outperformance in the Asian session, which advanced by nearly 1%. Concerns about escalating inflation pressures had prompted the BoK to move rates higher from July of 2010 to July of this year. Yet concerns over the implications of an uncertain global growth outlook have overshadowed inflation worries in recent months. Moreover, inflation moderated in September, as the CPI slowed to a 4.5% y/y rate from the three year high 5.3% y/y clip in August. Nevertheless, the central bank stated that inflation expectations remain high and core inflation is likely to remain on it’s upwards trajectory. Although it appears the Bank is sounding a bit more dovish on the growth outlook, we suspect that the softening of the currency is likely to have eased financial conditions enough to keep the bank from cutting rates anytime soon. Elsewhere, China’s exports rose 17.1% in September compared to the same month last year. That is moderation from the 24.5% y/y pace in August and the slowest growth rate since the 2.4% y/y clip in February of this year. In LATAM, after Mexico’s dismal Aug. industrial production we believe it is likely that Mexico could cut rates. We believe it is not a done deal but the OIS market places a greater than 80% chance that the policy rate drops by 25bps to 4.25%, in spite of the fact that inflation remains close to the 3% target. The main driver, on balance, appears to be the slowdown in the global economy, US in particular, with Mexico’s exports to the US accounting for nearly 73% of its total.