Successful Auctions Boost Tone in Europe

BBH CurrencyView

• Better than expected reception to Spain and Italy’s debt auctions have spurred risk on; dollar softer
• BoE, as expected, left policy unchanged, ECB expected to do the same; Japan’s current account shrinks
• US advanced retail sales expected to rise to 0.3% from 0.2%; thoughts on the EM central bank outlook

After consolidating some recent gains yesterday the dollar is on the back foot again this morning following strong results from Spain and Italy’s debt auctions. While we think it is too soon for further measures from the ECB, the better than expected reception to Spain and Italy’s debt auctions have spurred “risk-on” with the euro moving into the range that appeared to have been broken yesterday. Equity markets and EMs are also moving higher with the BRL and ZAR leading gains, advancing over 0.7%. European bank shares are leading gains, up 4%. Hungary also sold more than projected in its auction, HUF44bn vs. its 33bn goal, boosting sentiment. As expected, the BoE kept policy unchanged, but we continue to expect it to move forward with more QE once this round of purchases is complete. Elsewhere, Swedish inflation slowed for the fourth month in a row amid a slowdown in economic output, driven by the intensification of the euro zone debt crisis.

Spain and Italy both saw borrowing costs plummet at bond auctions amid strong demand. However, risk lies with the bond sale tomorrow, especially with the large increase in Italian bond prices today as the 5-year yield is off 60bp and the 10-year yield has dropped about 40bp. The year is long and the amount that the sovereigns and banks need to raise is large. It is worth reiterating three main points in our analysis. First, amount of maturing bonds and coupon payments in January are roughly balanced. This provides a supportive environment for this month’s auctions. This advantage deteriorates next month. Second, the 3-year facility by the ECB and the lower cost of accessing dollar funding reduces the extreme tail risks in the EZ. This was an important step in the crisis response. Third, there will continue to be "natural" buyers of European sovereign bonds. Even if not all the foreign holders will roll-over their maturing issues, many domestic investors, like banks and pension funds, likely will. The parallel we point to is a year ago, when many were asking who would buy US Treasuries after the Fed’s program ended. Lo and behold, US yields fell more in the six months after the Fed finished than during its operation. And now one of the largest fixed income managers in the world is reported to have recently increased his exposure to Treasuries.

On the data front, Japan’s current surplus totaled ¥139bln, much below expectations and representing a nearly 86% drop from the surplus seen in November of last year. Above all, exports dropped on diminishing global demand, while higher oil prices drove up energy imports. Trade in services, however, improved mildly from -¥275bln in October to -¥115bln, netting the total trade in goods and services at the lowest since August 2011. Investment income also shrank. While it remains likely that Japan’s overall current account balance is likely to remain in surplus for some years to come (thanks to the large external balance), demographic pressures will also pose headwinds for Japan moving ahead. Indeed, 2012 in slated to be a watershed year when the biggest wave of baby will begin to retire and start to draw down on their saving. We still expect the USD/JPY to remain range bound, but with the compression of G10 yield differentials and market sentiment still sensitive to euro zone developments, we expect the bias for the USD/JPY to remain on the downside. Resistance expected near 77.28, with support seen near 76. Elsewhere, today brings advance US retail sales, where the consensus expects a rise of 0.3% on both the headline and ex autos. The headline is likely driven by the surge in retail spending during the holiday season. This is likely to be offset by softer gasoline station and auto sales but the acceleration in chain stores sales is consistent with strong retail sales ex gas, autos and building materials. However, with income growth weak there is a still a danger that consumption growth will begin to stall.

This week may be remembered as a small hawkish bump in an otherwise dovish environment for EM central banks. Overnight, the Bank of Indonesia kept its rates on hold against a growing number of calls for cuts. As we expected, the weaker IDR and concerns about the impact of forthcoming reduction in subsidies have kept the bank vigilant. In China, slightly higher headline inflation numbers overnight sparked calls for less aggressive monetary policy easing. We disagree. At most, RRR cuts will be delayed a bit, as has already been signaled by a few PBoC members. Later today, Chile’s central bank meets and may disappoint calls for a cut of 25 bp to 5.0%. Inflation in December came in much higher-than-expected and could trump concerns about slower growth for now. Plus, copper prices have trended higher over the last couple of months. The Bank of Korea meets tomorrow. We expect rates to be kept on hold at 3.25%, given still high inflation, with little chance of a surprise. Front-loading of 2012 fiscal spending in Q1 is planned, and could boost activity and allow the BOK to remain on hold until price pressures ease in the coming months.