New Governments, Same Problems

BBH CurrencyView

• Markets failed to get a lasting boost from change in EZ governments; dollar broadly higher into open
• Italy auction met with decent response, but higher yields nonetheless ; change in governments no panacea in EZ
• Japan’s preliminary Q3 marks the end of the recession; Hungarian forint weakest currency on the day

The European morning had a more subdued tone after it was unable to sustain the relief rally in Asia (with the MSCI Asian Pacific index up 1.2%), encouraged initially by the political developments in Italy and Greece. Indeed, markets failed to get a lasting boost of confidence from Berlusconi’s departure as European stocks corrected recent gains and posted moderate losses following the results of the Italy’s 5-year auction, which saw refinancing costs rise to a 14-year high. The Spanish 10-year is also 12bps higher on the day. European banks shares are currently down 1%. The calendar today had euro zone September industrial production, which dropped 2.0% m/m, broadly in line with expectations, supporting expectations for a modest gain in tomorrow’s Q3 GDP. Elsewhere, Japan’s preliminary Q3 GDP rebounded, marking the end of the recession, while NZ retail sales surged in Q3 2.2% SA in Q3 following +1.0% Q2 driven in part by the Rugby Cup.

Over the weekend, like many times before, the Europeans delivered the necessary policy response to avert a meltdown with both Italy and Greece moving to install national unity governments, led by technocrats. The near term advantage of this type of government is that both governments are likely to enjoy broad parliamentary support to move forward with their reform agenda. But, for sure, this is unlikely to be a silver bullet and many questions still remain. In Italy even with new technocrat government in charge, Berlusconi’s People of Liberty Party remains the largest political force in parliament. It still remains possible that this party attempts to stall the necessary reform agenda in order to progress their political agenda. At the same time, in spite of the shift in government in Greece, it is still unknown whether Greece will receive its next aid tranche. Recall that Greece runs out of money in mid-December and as a result will need to receive this tranche in order to avoid a disorderly default. What’s more, this weekend Spain goes to the polls and with the opposition party gaining momentum ahead of the important vote political uncertainty in the euro zone is likely to remain high. A change in Spain’s government, above all, is likely to see erosion behind any momentum to implement further austerity measures, which in turn would likely lead to higher Spanish yields. Lastly, today’s soft industrial production data is likely to support the notion that the sharp deterioration in confidence over the past few months, together with the drop in new orders, suggest that Q4 activity is likely to stagnate. To us, outside of brief short covering rallies, we expect the euro to remain under pressure in the coming weeks and ultimately end the year around our yearend target of 1.29. This week we expect the EUR to remain in its broad range of 1.348 – 1.385, with the euro currently ahead of a key support level near 1.365.

Beyond Europe, Japan’s first preliminary Q3 GDP rose expanded 1.5% in Q3 (q/q, sa) after the 0.3% contraction in Q2 and declines in Q1 and Q4 of 2010 as consumption and exports rebounded from declines brought about by the March earthquake. A breakdown of the expenditures showed private consumption grew 1.0% in Q3, while net exports contributed 0.4% to GDP growth. Corporate capital spending increased 1.1%. At the same time GDP rose 6.0% on an annualized basis (q/q, saar) after a 1.3% drop in Q2. While the rebound in Q3 GDP ends the recession, the growth rate should prove unsustainable in Q4. In fact looking ahead output growth is likely to moderate from here off the back of the recent global financial market stress. As a result, post earthquake recovery momentum should fade with eroding confidence likely to slow consumption spending and net exports should suffer from the combination of weaker global growth and a strong yen. The BoJ meets this week but is unlikely to adjust policy. Still, we expect the yen to remain firm as intervention risks fade, with a re-test of 76 expected.

The Hungarian forint is the weakest currency today, dropping more than 2% against the US dollar, following the pre-weekend warning from S&P and Fitch could cut the country’s ratings to below investment grade by the end of the month. The forint is at its weakest level in 2 1/2 years against the euro. The forint’s weakness appears to be reflecting capital flight. Ten year bond yields are up 31 bp today. With the market demanding higher yields, the government rejected all bids at its 6-week bills auction. Separately, note that data released today shows that domestic banks borrowed euros from the central bank to cover almost 40% of the early repayments of foreign currency loans under the government scheme announced at the end of September. In turn those euros provided by the central bank reduced its foreign assets and reduced liquidity in the banking system. The risks are increasing that Hungary is forced back into the arms of the IMF.