Spain’s Downgrade Shrugged Off Amid Hopes of Crisis Plan

BBH CurrencyView

• Equity markets are mostly positive after strong gains overnight; supported by euro zone crisis plans
• EUR firms despite Spain’s rating downgrade by Moody’s; Norges Bank expected to remain on hold
• Japanese and South Korean policy makers reach agreement to increase currency swap line to $70bln

Global stocks are mostly higher in part following a strong close on Wall Street after some better than expected earnings results and encouraging signs that Europe is working towards a bold policy solution. Asian stocks were boosted in part from the large increase in the FX swaps deal between Japan and South Korea, which is also expected to address yen funding concerns. As a result, risk appetite has improved and the dollar is declining against nearly all of the G10 and EM currencies, although the BRL is flat ahead of today’s central bank meeting. We are in line with consensus and expect the BACEN will cut by 50bps, but we suspect the risks are skewed towards a hawkish surprise. Meanwhile, sterling dipped after the BoE minutes showed a unanimous vote from QE and some even called for bigger stimulus, while Japan’s August indices of all industrial activity fell 0.5%, the first drop in five months. Elsewhere, the Bank of Thailand kept its policy rate on hold at 3.5%. Oil up 0.3%.

Today markets are shrugging off the news that Spain was downgraded by Moody’s two notches to A1 off the back of reports that European leaders are considering boosting the firepower of the EFSF — upwards to €2trn. However, we would suspect that expectations of an early comprehensive solution are unlikely at this juncture and in fact European press reports have already tried to downplay expectations, suggesting that the limit for leveraging the EFSF will be €1trn and ultimately will be based on an insurance model that has not yet been finalized. Indeed, currently there are two versions under discussion, one that covers initial losses up to a fixed percentage (probably 20%) and a second that sees the EFSF as a backup insurance, with investors covering initial losses. We suspect that of the two the second one is likely to be the best option for restoring market confidence. Nevertheless, we expect the EUR/USD to remain short of Monday’s highs ahead of the Greek austerity vote tomorrow and equally important ahead of this weekend’s ECOFIN Summit. What’s more, the 38.2% retracement comes in near $1.3620 and a break of that would suggest $1.3530-50. In Norway, the central bank meets this morning is expected to keep its policy rate unchanged at 2.25% for the third consecutive meeting. The OIS market, meanwhile, is looking for a 25bps over the next few months and looking further ahead is pricing in the probability of a 50bps rate cut over the next year. This is likely a reflection of global turmoil over the past few months and largely explained by the uncertainty facing Europe amid the intensification of the sovereign debt crisis. Arguably, the rates market is likely ignoring that fact that despite the ongoing travails in the EZ Norway’s domestic data remains firm. The overall magnitude of data surprises has in fact recently exceeded expectations by nearly 1.5 standard deviations. Altogether, with a cut largely priced into the market expectations we doubt a dovish rate outlook and statement is likely to have too much of an impact on USD/NOK.

The BoJ expanded the JPY/KRW bilateral swap line to $30bn, established a new 1-year USD/KRW line worth $30bn, and provided Korea with another $10bn under the multilateral swap agreement called Chiang Mai Initiative (CMI) between ASEAN countries. The new funds provide an extra liquidity buffer for Korean companies and banks that have large foreign debt liabilities. As a result, the move strengthens our positive relative value view towards KRW against most other regional currencies and should also be supportive of Korean assets in general as it further reduces the risk of another funding squeeze. It should accelerate the normalization of the USD/KRW cross currency basis swap rate. The move should be seen in the context of competition for political influence in the region between Japan in China. The early stages of the CMI were marked by Japan and China jockeying for leadership over the program. The move by Japan to go the bilateral rout could be interpreted as payback for the appointment of a Chinese national as the effective head of the CMI. It can also be seen as balancing the many bi-lateral swap agreements the PBoC established with emerging market countries after the crisis, including Indonesia, Malaysia, Singapore and South Korea. Looking ahead, the Brazilian central bank meets today. BACEN will cut by 50bps in our view, but the risks are skewed towards a hawkish surprise, most likely in the statement’s language or later in the minutes. We think enough variables have changed in the global backdrop to justify the bank starting to signal a less aggressive pace of cuts going forward, especially when considering that inflation and inflation expectations remain elevated.