Dollar Falls on Fed, Potential Greek Debt Deal

BBH CurrencyView

• Dollar extended losses overnight and into the European session following the Fed’s dovish policy stance
• Global stocks are broadly high off the back of Fed and Greek debt deal; EuroStoxx up 0.6%, banks up 0.7%
• Economic data saw German consumer confidence improve; UK’s CBI retails sale retrenched in January

The dollar extended losses overnight and into the European session following the Fed’s surprise move to extend its conditional commitment to low policy rates through 2014. The euro was also supported after Greek media reports said private creditors are willing to accept a coupon rate below 4% on the new Greek bonds, along with a strong Italian bond auction, leading periphery yields lower (though Portuguese yield continue to rise). As a result, the euro and other growth sensitive currencies are higher with the Australian dollar leading the gains against the dollar in the G10, up 0.6%. In EM, the South African rand was among the best performers despite talk of SARB intervention buying USD/ZAR on a break below 7.86.

Greek PSI talks resumed today as the parties involved try to reach an agreement on the average coupon for the deal. The banks (via IIF) have said their best offer is already on the table, but the fact that they are back for more talks suggests otherwise. It should be no surprise that the IIF has called for the public sector to take haircuts, but developments over the past few days suggest discord within the troika over this issue. In particular, OECD Secretary General Gurria suggested that an ECB haircut was feasible since most of its Greek bond holdings were bought at a discount, something that we have suggested too as a possible compromise. There are many moving targets right now, but our base case remains that a PSI deal will be reached in the coming days. Consensus on haircuts for the public sector remains elusive, but will not have to be addressed for the time being if PSI deal is reached soon. Markets appear to have priced in an eventual PSI deal at this point, and the euro continues to march higher. Break of 1.32 would target Fibonacci levels from the October-January drop in EUR/USD at 1.3244.

The key takeaways from yesterdays Fed meeting, which surprised markets by extending its conditional commitment to low policy rates through 2014, are twofold First, while some observers felt the big surprise yesterdays was the more dovish response, we suspect that the adoption of a formal inflation target was the big surprise. Indeed, along with a strategic move towards providing more transparency in order to improve communications with markets, the Fed chose to release an explicit long-term inflation target of 2% on the PCE price index. In substance, there is not a big difference from the informal target but nevertheless we suspect a formal inflation target is likely to be more efficient at influencing investor behavior, while still pursing maximum employment implied by its projections. The US rates market has reacted thus far by taking yields in the belly of the curve sharply lower as a result. Second, in the summary of economic projections the newly added tables showed that of the 17 FOMC participants surveyed, 6 expected the first hike to come before 2014, 5 expected the first hike in 2014 and the other 6 anticipated the first hike would not be until 2015. On this front, the outlook provided by the Fed should be view as a forecast, not a commitment. That means, if the US economy deviates from expectations then the Fed is likely to alter the policy rate before (after) the published projections. What’s more, we think the range of forecasts is likely to be skewed by the non-voting members, who in the end may be less influential than the voting members. We still view QE3 as unlikely in H1. Given stretched market conditions, we suspect there is further scope for USD depreciation in the days ahead.

Hawkish comments from central bank heads of Russia and Poland only increased our positive view towards the RUB and PLN. In Poland, Governor Belka stated that a rise in rates is possible, and despite market expectations for a cut, only a “very dramatic” economic slowdown would lead the NBP to start easing. We take this at face value and note the contrast with the central bank of Hungary which surprised markets by not hiking rates earlier this week. The favourable cyclical story only adds to our conviction that PLN should outperform the region in the medium term given its stronger fundamentals. We continue to patiently wait for the right time to re-establish a long PLN/HUF position. Still, EUR/PLN is rapidly approaching the next key resistance which is the 200-day MA at 4.2133. In Russia, central bank Deputy Chairman Ulyukayev speaking in Davos said that rate cuts are off the table for now since inflation has collapsed. The fall in inflation was attributed to one-off factors such as the delays to utility price hikes which will kick in later this year. The ruble is catching up with other EM currencies on the back of positive risk appetite, prospects for tighter monetary policy, subsiding domestic political risks and rising geopolitical risks supporting oil prices. Should risk appetite hold up, USD/RUB could break the next resistance levels on the downside, at 30.0 and then the 200-day MA at 29.74.