Market Tone Remains Upbeat after Euro Zone Auctions

BBH CurrencyView

• Dollar continues to trade on the back foot as markets maintain upbeat tone; strong EZ auction results
• Soft Australian December employment reports supports Feb rate cut; BoC likely to remain on hold in H1
• SELIC rates likely to fall but the government may act to stem BRL appreciation; Philippines CB cuts by 25bp

The dollar continues to trade on its back foot as markets continue to maintain an upbeat tone after the recent flow of positive news developments. The euro managed to extend yesterday’s high and currently trading just above 1.291, which also happens to be a key level of resistance. A convincing break would open the door to test the recent high near 1.307, while near term support is seen near 1.277. French 10-year spreads over bunds continue to narrow following strong auction results, although Portuguese yields remain under pressure. Adding to the positive sentiment are hopes that Greece will agree a deal with its creditors, thus ending the chance of a disorderly default by Athens. As a result, the EuroStoxx 600 extended its best level since August 3, 2011, led in part by the 3.8% rise in bank shares. In Asia, the MSCI pan-region index rallied by 1%. Elsewhere, in South Africa the SARB meets today and we, along with the consensus, expect them to remain on hold.

Recent debt sales in the euro zone have gone fairly smoothly. Today’s French €8bln sale is of note, being the first one since it lost its AAA rating from S&P. As further evidence that the ratings agencies remain behind the curve, French borrowing costs actually fell. A similar dynamic was seen after the US lost its AAA last summer. Spain was also able to sell EUR6.6 bln of debt today at lower borrowing costs. No more debt sales are scheduled for this week, but there is another slug of short-term paper to be seen next week from Germany, France, Netherlands, and Spain. EUR/USD today broke a downward sloping trendline dating back to November, which points to further gains ahead. It is currently bumping up against resistance around 1.29, but break of that Fibonacci level targets a retest of the 2012 high around 1.3077. While we do not believe the euro zone is out of the woods yet, the aggressive ECB measures taken have clearly helped to stabilize the situation. Today’s reported drop in commercial bank deposits at the ECB to EUR395.3 bln from a record high EUR528.2 bln yesterday is due largely to the start of a new reserve maintenance period. However, we would expect some of the drop in deposits to have found their way into the sovereign debt sales today. The ECB will offer another tranche of 3-year LTRO on February 28.

In the dollar bloc region, recent developments support our view that the RBA is likely to continue to ease policy, while the BoC remains in wait-and-see mode. Australia’s soft December employment report points to further RBA rate cuts. In particular, the labor market lost 29.3K jobs much weaker than consensus forecast for a 10k gain. The details of the report were also soft, with the gain of 24.5K full-time jobs offset by a loss of 53.7k part-time jobs. Slowing employment is likely to be a headwind for domestic demand and weigh on consumption growth. As a result, we expect the RBA to cut again by 25bps in February. In short, we continue to think that the AUD remains sensitive to global developments, EZ stress in particular, and the RBA outlook and therefore we expect the AUD to finish the quarter at 0.94. In Canada, yesterday’s monetary policy report provided additional backing for an expected period of steady policy. Europe’s sovereign debt crisis and rising risk aversion remain the key downside risk to Canada’s economy. However, the Bank’s base case remains for containment of Europe’s sovereign debt crisis. The Bank also expects the US recovery to continue, albeit at a relatively modest pace through 2013. Overall, we expect the current level of accommodation to remain appropriate and as result expect the BoC to remain in wait-and-see mode. We expect the CAD to outperform other dollar bloc currencies and finish Q1 at 1.06. Next level of support seen at parity, with resistance seen near 1.0203.

SELIC rates will continue to fall but the government may act to stem BRL appreciation. The Brazilian central bank cut rates by 50bps to 10.50% as widely expected, keeping the language of the statement unchanged. Markets have trimmed their expectations for SELIC cuts this year. According to future markets, rates will trough at around 9.75%, though many local analysts are calling for rates to fall to 9.00%. We stick with our base case of 9.50% for now. Finance Minister Mantega recently started once again to talk about measures to stem BRL’s appreciation. It is understood that the government has a preference for USD/BRL around the 1.80 level. We see no reason to doubt their resolve to act again and would advise investors to be cautious as we approach the 1.75 level. The Philippines central bank lowered its target rate by 25bps to 4.25%. near-term PHP outlook will be driven largely by broad market risk, but the peso has been a good low-beta currency in EM. Even with today’s interest rate cut, PHP still provides a substantial yield. If risk on prevails we target the 43 area that represents an upward sloping trendline from August.