Time is Running Out for Decisive Policy Action

BBH CurrencyView

• Another volatile session marked by choppy overnight trading; global stocks mixed overnight
• Euro zone summit unlikely to draw a line in the sand; German Ifo somewhat better than expected
• USD/TRY managed to keep most of its gains following CB action; focus on Mexico’s unemployment

Markets continue to remain cautiously optimistic (but nerves remain high) going into this weekend’s euro zone summit. Indeed, risky assets remain mixed in part from confusing headlines from the euro zone, announcing another summit for 10/26, despite the continued improvement in US economic data. Ahead of the Asian session, markets rallied on the back of a fresh proposal suggesting that the increased firepower required would be achieved simply by combining the lending power of the EFSF (€440bn), with the ESM (€500bn). Admittedly, this would not be a quick fix since it would require a change in the treaty and thus would need to be voted on by all member countries. Nevertheless, EZ stocks are higher on the day with the benchmark index led by the 1.7% rally in banking shares. Canadian CPI exceeded expectations, suggesting the BoC is likely to remain on hold.

There is little doubt that this weekend’s first of two Summit meetings is likely to be the main events over the few days. As such, we expect markets to remain jittery and for price action to remain choppy, given the difficulties policy makers have in solving the euro zone debt crisis. While the “top up” in the potential firepower of the EFSF is likely to be delayed until sometime next week, market expectations are likely to hinge on a package with three potential elements, barring the expansion of the EFSF. For one thing, many suspect a program for bank recaps to be announced with recent estimates from euro zone policy makers suggesting banks may need upwards to €100bln. Next, is increasing the size of the haircut on Greek government debt, with possible write-downs in the range of 40-60%. And finally, some observers believe that it is likely that euro zone policy makers bring forward the operation of the ESM (mechanism setup to replace the EFSF and deal with orderly defaults) to mid 2012, rather than 2013. While we think these measures would likely be a step in the right direction, we suspect that they solutions are unlikely to provide closure for the markets and thus we expect the markets to be disappointed in the outcome. As a result, we see near-term downside potential for the EUR/USD but expect the currency to remain within its current range.

On the data front, while there are no key data reports to focus on in the US, European data was somewhat better-than-expected. Indeed, both the German Ifo and UK public borrowing were encouraging. Nevertheless, the takeaway from the Germany Ifo report is the sharp deterioration in recent months highlights that the financial crisis has severely impacted the real economy and the overall economic outlook and is threatening to push the euro zone into recession if officials don’t manage to get the situation under control soon. In fact, despite the rise in the headline the most useful leading indicator for growth is the forward looking expectations subcomponent, which remained flat from the previous month. Using a lead time of a few months the expectations component remains consistent with positive, but very sluggish growth that narrowly borders a recession. Meanwhile, the UK public sector data shows that while the government is half way through the first year of its five-year plan to eliminate the budget deficit, it is nonetheless so far on track. However, the stagnating economy is likely to make the government’s ambitions a bigger challenge during the second half of the financial year (the UK’s financial year runs from April to April), particularly the rise in unemployment and the obligation to raise jobless benefits in line with inflation.

In EM price action TRY managed to keep most of its gains following the central bank’s decision to signal tighter policy in yesterday’s meetings. Today, the bank reduced its USD auction maximum amount to $350nn, down from $750 yesterday. It remains to be seen if the combination of continued USD sales and prospects for higher carry will finally stem the lira’s decline. We are still skeptic and see yesterday’s central bank move as the bare minimum the bank could have done. As highlighted in yesterday’s report, beyond lack of policy credibility, we are also concerned about inflation, the currency account deficit and growth in Turkey. However, we do recognize that short TRY position may be extended and see the risk of sharp short covering driven rallies. In LATAM, Mexico’s unemployment rate is likely to suggest that demand continues to remain weak. The market expects September’s unemployment to increase to 5.85% from 5.79%. We expect that the central bank is likely to remain on hold in December. On the whole, in terms of price action a risk of a short squeeze on breaks above 13.80 remain likely ahead of this weekend’s EU Summit.