Greece Debt Talks Remain in Focus Ahead of the Weekend

BBH CurrencyView

• Dollar pares back some of its recent losses ahead of the weekend; focus on Greek debt negotiations
• A leaked draft of the new EZ fiscal pact contains tougher rules; growth sensitive currencies top performers
• We, along with the consensus, expect the Mexican central bank to remain on hold; China’s flash PMI

The dollar is consolidating some of its recent losses, with the euro declining from a 2-week high, as markets awaits the decision on Greek debt deal negotiations. The euro ran out steam around 1.30 and is currently trading near 1.291. The Swedish krona and the South African rand are the two worst performing currencies both down over 0.5% following a strong performance on the week, with the krona up nearly 3% this week. On the data front, German December PPI decelerated more than expected to 4.0%y/y from 5.2% y/y. In the UK, December retail sales came in near expectations at +0.6% m/m, recovering from November’s 0.5% m/m decline. Asian stocks extended to two-month highs, with the MSCI Asia Pacific index up 1.2%, after broad gains in the U.S. and Europe Thursday. However, European shares appear to be in correction mode after making a five-month peak yesterday. The EuroStoxx is currently down 0.4%, with bank shares up 0.3%. Canada CPI fell to a 2.3% annual rate in December, well below expectations (consensus +2.7%) from the 2.9% clip in November.

The euro recovery has stalled just below 1.30. Greek media is reporting that the PSI agreement has been reached, with new bonds to be 30-year maturity with a coupon that starts at 3.1% and could move to as high as 4.75%. The story suggests that IIF head Dallara will make an announcement from Athens later today, and confirms similar leaks of a deal earlier this week. However, some profit-taking appears to be taking hold ahead of the weekend in many markets, and markets most likely realize that once the Greek PSI deal is reached, other countries remain in trouble. A leaked draft of the new euro zone fiscal pact contains tougher rules and automatic penalties for any country that. The matter is still under discussion and will be discussed at the January 23 meeting of Finance Ministers. What the leaked document shows is that the German/ECB emphasis on austerity remains a pillar of the crisis response. While that may help prevent future crises, continued austerity now will only make deficit targets harder to meet.

In the G10 the past week showed the SEK, NOK and the EUR among the best performing currencies. To some degree this is also consistent with the price action year-to-date with dollar underperforming against most of the European and growth sensitive currencies. Sterling, however, continues to be a bit of a laggard, but given the broad weakness in economic data over the past few weeks, sterling’s gains are likely a function of improving risk appetite and market sentiment. The key driver of the price action across the G10 continues to be the recovery in risk appetite off the back of the actions taken by the ECB to boost liquidity and the improvement in US macro data. ECB actions are likely in part to have also contributed indirectly to the solid periphery auctions seen thus far this year as periphery yields have fallen. On balance, the Dec. 20 announcement by the ECB of expanded lending arrangements appears to have been the catalyst for the short covering rally amid the reduced fears of a funding crisis in Europe. We expect this short covering rally to continue for the time being but we see important downside risks for the euro over the coming months, stemming from economic weakness and political uncertainty. After all, many G10 currencies remain sensitive to a shift in sentiment due to the extreme short positioning against the dollar but once this rally has run its course we expect dollar strength to persist.

The Mexican central bank announces its rate decision later today and is expected to keep rates steady at 4.5%. Despite better than expected US growth, Mexico real sector has been coming in on the weak side recently. As such, any talk about a Banxico hike this year due to rising inflation (3.8% y/y in December) should be discounted. We see rates on hold this year, with a bias towards easing if the economic outlook deteriorates. Bloomberg consensus is still for 25 bp cut in Q2 after markets gradually priced out the risk of cut in Q1. Indeed, 1-year swap rates (TIIE) are up 40bp from its low point in September last year. USD/MXN appears on track to test the 13 level, but much will depend on market sentiment regarding euro zone crisis. If positive sentiment continues, there is scope for a move below the USD/MXN 13.00 level. China flash manufacturing PMI (HSBC/Markit) improved slightly to 48.8 in January from the final reading of 48.7 in December. That leaves the index still in contractionary territory, but could prompt some optimism given that the index has clawed back from the low seen in November’s final release. The "flash" PMI is a preliminary figure — the final reading due on February 1. Recall that the official manufacturing PMI (CFLP) rose to 50.3 in December from a 49.0 figure in November that was the first contractionary reading since February of 2009. Overall, the official and HSBC/Market PMI’s continue to track expectations for less robust, but still strong, growth in China’s economy this year and reinforces our view that the government has scope to continue loosening policy.