Sentiment Improves on Hopes for Bank Recapitalization

BBH CurrencyView

• Sentiment continues to improve ahead of NY open off the back of possible EU bank recapitalization plan
• For sentiment to continue to improve markets are likely to need a bold policy response and better economic data
• Poland’s is expected to remain on hold, inflation risks; In South Korea reserves fell by $8.8bln

Market sentiment continued to improve overnight and into the European session following the 4% rise in the S&P in the last hour of trading on Wall Street off the back of European plans to recapitalize its banks. Comments from IMF’s Borges suggested that IMF could also play its part in supporting the secondary bond market and followed Japan’s willingness to up its investment in EFSF. As a result, stocks continue to move higher, while short-term bund and gilt future push lower, with Moody’s rating downgrade for Italy having limited impact. Admittedly, the ECB is reportedly in the market buying bonds again but European banking shares are up nearly 2.5%, suggesting that the impact from the downgrade is likely to be negligible. EZ data showed softer PMI and retail sales.

For the recent consolidation in risk appetite to hold and more importantly for it to be maintained in the coming weeks the markets in some part need to see a bold policy response from Europe and a continuation of better economic data performance. On the first front the markets appear to be reacting positively to a press report that finance ministers in Europe are looking for ways to recapitalizing financial institutions, despite the fact that Italy’s debt was downgraded three notches to A2 with a negative outlook. It appears that the combination of the sharp deterioration in market sentiment has resulted in a collective resolve in an attempt to deal with the euro zone crisis. Admittedly, these are still early developments and like previous proposals this would still need to be approved at national government level before implementation. But the potential for a bank recapitalization, more accommodative ECB policy and in time a larger EFSF could be what’s needed to avert another meltdown. We suspect that the EUR/USD is driven in part by a combination of risk appetite and position squaring ahead of the ECB meeting tomorrow.

Looking ahead to tomorrow we continue to suspect that a rally in stocks and sentiment is likely to support the euro given the sharp swing positioning seen over the past few weeks. Elsewhere in Europe, UK September services PMI unexpectedly rose to 52.9 from 51.1, much better than the 50.5 consensus forecast. The rebound follows what had been in August the second biggest fall in the data series on record, in falling from 54.1 to 51.1. The headline data caught market attention as the UK service sector accounts for about two thirds of the total economy, and should lessen the odds of a QE2 announcement tomorrow by the BoE. However, a grey lining still remains in the UK economy, with businesses expectations for the next 12 months falling to its weakness since March 2009. That said, overall, the data shouldn’t not deter expectations for the BoE to commence further QE in November or December. In the North American session today market will surely be focused on the ADP and US service-sector ISM. Both are expected to soften from last month with the market positioned for a downside surprise, which means a better than expected print from one or both would likely boost risk appetite, leading the dollar to selloff the more highly correlated stock currencies, AUD and CAD, to advance.

In the EM space today markets are likely to be focused on central bank policy and data. In Poland we are line with the market and expect the NBP to remain on hold and to reaffirm its wait and see approach for subsequent months. In our view, the central bank remains cautious about currency weakness feeding into inflation which is likely to keep from cutting rates for the time being. The increased uncertainty associated with the current market turmoil in Europe is likely to warrant a gradual pace of easing later on in the year or early into 2012 but due to concerns for a sharp increase in inflation we expect for now that the NBP’s refrains from cutting. Nevertheless, the EUR/PLN is likely to driven in some part by the backdrop for risk appetite and with a swift resolution of the euro zone debt crisis a ways off we see the risks for the PLN to the downside, although extreme currency weakness is likely to be mitigated by the potential for NBP intervention. In South Korea, FX reserves fell less than expected in September with the BoK FX reserves falling by $8.8bln. And although this is likely to understate the BoK’s FX intervention, it underscores that some of the intervention may have taken place in the forward market. Admittedly, though, the drop in reserves highlights that amid deterioration in market sentiment EM central banks are indeed likely to use the reserves to defend the currency. And finally, inflation pressure in the Philippines rose less than the market consensus had been expecting with a 4.8% y/y increase in September, which was marginally below the consensus.