Dollar Firm As Italy Yields Rise, Euro Zone IP Falls

By BBH FX Strategy Team On Dec 14, 2011

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The dollar is broadly firmer as Italian yields rise at 5-year bond auction, euro zone IP falls
Swiss data weak ahead of SNB meeting tomorrow; Norges Bank seen cutting rates 25 bp
China data gives cover for more PBOC easing; RBA suggests AUD weakness will help cushion economy

The dollar is broadly firmer in narrow ranges as euro zone concerns remain in play. The euro is stabilizing after large losses Tuesday but support around 1.30 is being tested at the North American open. Euro zone continues to face a toxic mix of slow growth and rising borrowing costs, and so euro weakness is likely to continue. EM currencies are broadly weaker today, with INR the worst performer on the day vs. USD and ZAR the best so far. European shares are lower, with the EuroStoxx 600 down -0.9%, while bank shares are -1.4%. S&P future points to a down open. Periphery 10-year yields are mixed, with Italy, Portugal, and Ireland higher, Greece and Spain lower. JPY in 13 tick range.

In the absence of any major US data today, we expect the price action in the North American session to be driven largely by euro zone events. We were a bit surprised by market reaction yesterday to no change in Fed policy. For now, the US economy is doing well enough to preclude any QE3. On the flip side, ECB and other G10 central banks are back in easing mode, which is another supportive factor for the dollar going forward that is separate from the safe haven flows due to flare-ups in euro zone concerns. European data remains weak, borrowing costs diverge. Euro zone IP fell -0.1% m/m in October vs. flat m/m expected and -2.0% m/m in September. Italy sold EUR3 bln of 5-year bonds at a yield of 6.47% vs. 6.29% last month, while the bid to cover ratio fell to 1.42 from 1.47. However, Germany sold EUR4.2 bln of 2-year notes at a yield of 0.29% vs. 0.39% last month, while the bid to cover ratio rose to 1.4 from 1.1. Elsewhere in Europe, Swiss ZEW confidence fell to -72 in December from -64.3 in November, while Swiss PPI fell a greater than expected -2.4% y/y in November and highlights deflationary risks. SNB meets tomorrow, and while there has been some speculation of a hike in the EUR/CHF floor, we do not think it likely at this juncture. UK employment data was slightly better than expected, but ILO unemployment rate remains high at 8.3%.

Developments in DM outside the EU bear watching. The Norges Bank meets today and is expected to deliver its first rate cut since June 2009, 25 bp to 2.0%. However, the market is split with some calling for no change and some for 50 bp so beware of heightened volatility after the decision, whatever it is. In this tightening cycle, the Norges Bank has hiked 100 bp total to 2.25%. In this environment, however, rate decisions are having limited impact and we think NOK, SEK, and the other high-beta currencies are likely to remain vulnerable to negative euro zone developments. Meanwhile, RBA Deputy Governor Battellino seemed to signal official comfort with a weaker AUD. Like in EM, global growth-sensitive countries are saying that it’s all about the stimulus. Battellino said that while he is worried about euro zone developments, a weaker AUD would help cushion the real economy from the global fallout. RBA’s next meeting is February 7, which would come just before Battellino steps down as Deputy Governor on February 14. The RBA has cut rates twice now by 25 bp, first in November and again in December. Minutes from the RBA’s December meeting will be released December 19 and will be sifted for clues on future policy, but market is currently pricing in a 25 bp cut then to 4%. Overall, OIS market is pricing in 125 bp of RBA easing over the next twelve months that would take the cash rate down to 3%, which would equal the trough hit back in 2009.

China money and loan data for November were released, and give cover for the PBOC to continue easing. Overall loan growth eased to 15.6% y/y from 15.8% y/y in October, the slowest since October 2008 as new loans fell -4.2% m/m. M1 and M2 growth slowed also to multi-year lows. Tonight, HSBC flash PMI will be released, and we suspect it will continue to show weakness. However, an aggressive policy response from China is expected and we remain in the soft landing camp. PBOC has slowed CNY appreciation, which is at 0.2% QTD vs. around 1.3% gains in recent quarters. There is a risk that appreciation is put on hold temporarily, but we think outright depreciation is very unlikely. The South African rand remains vulnerable in this environment, as the economic fundamentals continue to deteriorate. South Africa November CPI was reported at 6.1% y/y vs. 6.2% y/y expected and 6.0% y/y in October. SARB has warned that inflation would breach the 3-6% target "temporarily" and so we see no rate hike in response to this. However, it does complicate matters and will likely prevent the SARB from cutting rates near-term in response to the slowing economy. We do see SARB easing in 2012. Add in growing twin deficits, and the recipe for a weaker rand is being put into place.