Euro Gyrates But Doesn’t Break

BBH CurrencyView

The US dollar is trading on the back foot against most EMs and the dollar bloc currencies but is firming against some European currencies after the release of the ECB’s second LTRO. European sovereign yields are mixed, with Greece and Portuguese bonds still under pressure. The euro fell amid a mild bout of buy the rumor sell the fact. The euro had tested the upper end of its recent range in Asia, setting a new high for the week, but unable to absorb the large offers around $1.35. It came off after the LTRO results, but initial support in the $1.3420 area held. Additional support is seen near yesterday’s low. Sterling is benefitting from the combination of better domestic data and technical momentum after recently breaking through its 200dma. The Swedish Krona is trailing gains behind other growth sensitive currencies after a weak Q4 GDP print, while Australian retail sales were in line with expectations, supporting expectations that the RBA remains on hold at next week’s meeting. Global stocks are mostly higher, with European stocks higher led by the rise in utilities.

At the ECB’s second LTRO, 800 banks took down €529.5B, slightly above consensus but within expectations. A little more than €200B reflects the rolling of other borrowing facilities into the three-year tenor. That more banks participated (800 vs 525) this time is not surprising as the relaxed collateral rules in seven countries, including Spain and Italy, were partly designed to help smaller institutions. While the greater participation would suggest the lack of stigma, a more telling indicator will be the relative performance of the shares of those banks that participated and those that didn’t. Consequently, financial shares are among the strongest in Europe. The larger number of banks participating also translates into a lower average take down. In the first LTRO, banks took an average of €935mln. At today’s operation the banks took an average of €691mln. The market’s focus shifts to three other issues. First, over the next two days Italy will make €30 bln coupon payments and redemptions. The interest seems to be on what Japanese investors do with their proceeds. Second, is the EU Summit starting tomorrow. The fact that the euro zone finance ministers meeting that had been planned for Friday has been postponed suggests that Germany is not yet ready to agree to combine the EFSF and ESM to build a bigger firewall. Third, ISDA’s Determination Committee has agreed to make a formal decision on whether the subordination of the private sector to the official sector is tantamount to a credit event. This will announced tomorrow. We suspect that ISDA will draw a distinction between de jure and defacto subordination. What has taken place is defacto subordination, by practice not be a change in bond terms themselves.

Japan industrial output (prelim) rose 2.0% m/m in January, extending the revised 3.8% bounce in December (+4.0%).The improvement in January was larger than expected, though the outlook for Japan’s economy remains cautious due to euro zone uncertainty, moderating external demand, and a strong trade-weighted yen. However, manufacturing firms surveyed by the Ministry of Economy, Trade and Industry anticipate a 1.7% rise in output during February and a 1.7% increase in March. This is in line with the recent improvements in the US ISM and European PMIs, suggesting that growth in the industrial cycle may begin to build momentum. Nevertheless, we expect the yen to be supported by the convergence of yields, with the 2-year US-Japanese government bond spread the main driver. This may limit the incentive for Japanese investors to invest overseas, thereby limiting Japan’s ability to recycle its current account surplus. The low yield differential also increases the incentive for Japanese investors to hedge out FX risk of current and future investments. In short, Japanese policy makers will need to be more aggressive in stemming the rise in the yen or allow for further strength. In the near-term, we expect the yen to remain range bound with support at 80.24 followed by 78.85; resistance at recent high of 81.67. Elsewhere in Asia, South Korea industrial production rose 3.3% m/m in January, much better than the consensus of -0.5% m/m. While the service industry growth slowed to roughly a 1-year low of 0.9% y/y, the rise in production is consistent with the message from the Japanese report, indicating that momentum is building behind industrial growth, even though external trade has shown some signs of weakness.

The bigger guns are coming out after USD/BRL closed below 1.70 yesterday for the first time since October, as we had warned. However, we are still at the verbal intervention stage. Comments from Treasury Secretary Arno Augustin late yesterday stated that the sovereign wealth fund is ready to be used to contain BRL strength, but that the central bank is still the first line of defense. Our take here is that the best authorities can do is to slow down the pace of appreciation, which is still largely driven by fundamentals (massive FDI numbers) and high carry (even if SELIC falls to 9.00% later this year). As such, the risk rewards for being short USD/BRL at these levels depends largely on the timeframe. In the short term, the BRL will get very choppy around the 1.70 level and we think there are better ways to express outright positive EM FX views, including MXN, PLN and KRW. For a longer term investment, however, the carry and prospects of gradual appreciation are very favorable.