ECB backs a weekly limit of 20bln euro for SMP purchases ahead of Spanish elections

• EuroStoxx 600 is off its lows but still down 0.4%, Asia shares mostly lower; dollar pares back gains
• ECB backs a weekly limit of €20bln for SMP purchases; Malaysia reports robust Q3 growth
• Looking at the four key drivers of dollar strength; This weekend (Sunday) sees Spanish elections

The dollar is paring back some of its recent gains ahead of the North American open after negative sentiment continued to dominate the Asian session. The European session has been marked by rather busy headlines with the euro breaking through the 1.355 level after news wires reported that the recent proposal of ECB lending to the IMF in order to support periphery countries is gaining traction. There was also news that was less euro supportive, suggesting the ECB backs a weekly limit of €20bln for SMP purchases. While a limit could be viewed negatively, the level of EUR20bn suggests plenty of upside relative to what the ECB has bought so far, given the ECB has averaged weekly purchases of nearly €6.5bln since Sep. Nevertheless, European shares (EuroStoxx 600) down for the fourth day in five, with banks down 0.4%. The highlight in EM Asia was the upside surprise in Q3 Malaysian growth, although we still expect the CB to cut into 2012.

Yesterday, we highlighted how the intensification of the financial stress – namely, the rise in banking and credit market costs, has weighed on EZ consumer and business confidence. The tightening of financial conditions, together with the austerity programs, is likely to be the ultimate drivers of the expected forthcoming contraction in EZ growth. Against this backdrop of increased financial stress and even concerns of a EZ breakup, many investors are likely to wonder why the dollar is not even stronger. For instance, assuming that the EUR/USD remains a function of the 2-year interest rate spread between the US and Germany, a regression analysis suggests that with current spread of 17 bps the EUR/USD should be trading near 1.28, all else equal. We suspect there are four key drivers that are limiting the dollar’s strength.

One, many observers continue to think that more aggressive policy action is likely from the Fed in early 2012. It also remains a possibility that the increased financial stress from Europe, which continues to impact the US credit market, may actually act as a trigger as a policy response from the Fed. Two, market positioning is skewed. Futures positioning and options pricing both suggest that the market is already positioned long USD, with the call-put premium implied from risk reversals on multiple currencies at historically “rich” levels. Investors are thus likely to remain cautious about extending long USD positions, given the potential from a policy response from European officials. Three, deleveraging by euro zone institutions has led to funds being moved into home countries and the euro. As part of the efforts to rebuild balance sheets and increase capital bases, euro zone financial institutions have been shedding non-core assets in EM. Those funds are going back to the euro zone and help keep a bid on the euro. And finally, the super committee deadline is next week and many suspect that policy makers will kick the can down the road, resulting in a fiscal drag on 2012 US growth. Given the potential for a more aggressive Fed response this is likely to be USD negative. However, we do believe that despite these headwinds, the worsening euro zone crisis will keep the euro on track to meet our year-end target of 1.29.

This weekend also sees the Spanish elections. While there may be some market impact on Monday, the results seem pretty well-telegraphed by recent polls. While Spain is in a better position politically than some of its other peripheral counterparts, the next Government still faces big challenges ahead. According to the most recent opinion polls, the opposition conservative party (PP) is likely to win an absolute majority. Consequently, this would free the government from relying on the support of regional parties and more importantly the PP has indicated that it will implement a new austerity program to ensure that existing budgets targets are met. It is also a staunch supporter of the euro and is determined to keep Spain in the currency union. One risk is that the PP comes in and announces that the budget numbers are worse than what the Socialists have been reporting. More austerity also implies difficulties in meeting future budgetary targets. A PP victory could provide some short-term relief to the euro zone peripheral debt market, but as we saw with Italy and Greece, the benefits can quickly wear off. As such, we would still advise selling euro’s into rallies with resistance seen near 1.360 followed by 1.37.