Contagion to the Core Raises Tail Risks

BBH CurrencyView

• Overnight price action marked by choppy trading conditions; Most EM stocks and currencies lower, safe havens advance
• North American session likely to focus on US data; Inflation expected to remain flat, industrial production seen higher
• The rise in euro zone core bond yields is likely to weigh on the euro; UK unemployment reaches 15-year high

Ongoing concerns of the euro zone debt crisis continue to weigh on sentiment ahead of important bond auctions from Spain and France tomorrow. The weakness was most acute in the EMs, Asia in particular, where stocks and currencies tumbled amid concerns over recent developments in the EZ bond market after Moody’s recently place a large Italian bank on review. China’s Shanghai index fell by 2.5% while the KRW was among the worst global performers, dropping by 1%. All told, safe havens remain in vogue with the USD, JPY and CHF all advancing. Elsewhere, the minutes of the Hungarian October central bank meeting showed it may have to gradually tighten policy and raise rates.

Today, the focus of the North American session is likely to remain on US data reports. Consensus is for CPI to remain flat m/m, and comes after yesterday’s lower than expected PPI report. This round of data may provide the clearest signs yet that price pressures are close to a peak. While we suspect a renewed threat of deflation is one of the most powerful triggers for another round of QE, a peak in inflation would bring a policy response from the Fed a step closer. Looking at the data, strong demand for rental space is likely to keep the OER component firm. Meanwhile, despite the slowdown in overseas activity, US IP has been growing at a fairly decent rate. This momentum was probably maintained in October (consensus is 0.4% m/m gain vs. 0.2% m/m in September), with the reported increase in hours worked likely to be supportive of manufacturing output. This is followed by the September TIC data, as many observers will continue to monitor the flows into US Treasuries. Recall that over the past few months international demand for dollars has gone hand in hand with purchases of Treasuries, with the August report indicating that nearly 90% of the inflows were into USTs. As a result of the intensification of the financial market stress in September, the stronger dollar and higher UST demand is likely to see big TIC inflows. Above all, the TIC data is likely to show that nearly all of the recent USD buying is off the back of safe haven demand and in turn would leave the USD sensitive to any slowdown of safe haven buying of USTs, though this appears unlikely just yet.

Market attention continues to remain on the euro zone bond market, with the euro unable to hold above the 1.35 level in spite of some tightening of euro zone bond spreads today. The euro is likely reacting to the growing concerns about France, Belgium, Austria and other core countries that threaten to take the sovereign debt crisis to a new level. A further rise in the these countries’ bond yields or further weakening of euro zone bank capital supports fears that some may end up unable to support the periphery, thereby leaving the burden mainly on Germany and potentially the ECB (which remains reluctant to act more aggressively in the peripheral debt market). For instance, France’s AAA bond rating remains under threat, which if lowered may undermine the firepower of the EFSF, which is important given the ECB’s reluctance to ramp up its SMP purchases. While fears about Italy have grabbed most of the headlines lately, there are signs of more widespread contagion from the euro zone’s periphery to other large economies, with spreads widening this week in Austria, France, and Belgium. While we expect the euro is likely to remain sensitive to headlines and short-covering rallies, we think there are further downside risks from here with a convincing downside break of 1.340 opening up the door to test the recent lows near 1.315.

In the UK the unemployment rate increased to a 15-year high as labor market deterioration continues afoot. Indeed, despite the better than expected claimants, today’s employment reports continues to show that labor market distress is intensifying, with September ILO jobless rate rising to 8.3% from 8.1%, above the 8.2% expected by the market. Average earnings in the three-months to September came in at 1.7% from 1.8% for the ex-bonus figure, and 2.3% for the including-bonus figure, having decline from 2.7% at the last reading. With October CPI inflation at 5.0%, earnings are continuing to fall in real terms, affirming the BoE view that second-round inflation effects have not taken hold, while the ongoing squeeze in incomes portends poorly for the retail sector. Looking ahead a host of forward looking surveys such as the latest quarterly CIPD employment report, together with the October batch of PMI surveys, showed that employment trends is likely to remain on a down path. This, combined with the expectations of a moderating inflation, based on today’s BoE Inflation Report, indicates the door to additional QE is open. We expect new purchases in Q1 2012.