Dollar Soft Ahead Of Stress Tests As European Data Still Strong

From the Brown Brothers Harriman Currency Strategy Team

Highlights

US dollar is mostly softer so far today vs. the majors, hurt by stronger than expected data out of Europe (see below) ahead of the European bank stress test results around noon EST.  The euro has recouped most of this week’s losses as the 1.27 area held Thursday, and markets appear sanguine about the stress tests despite doubts being raised by analysts regarding assumptions behind those tests.  The yen was mostly softer, suggesting risk aversion has eased further, while the Swiss franc is mixed.  EM FX was firmer, with Hungary being the exception due to the Moody’s downgrade (see below).  Biggest gainers on the day so far vs. USD are GBP, PLN, INR, KRW, and PHP, while the only losers vs. USD so far today are CAD, HUF, AUD, and JPY.  PBOC set the daily fix for CNY at its strongest level this week, and continues to push more two-way action in the exchange rate.   

Asian markets were higher on carry over from US rally Thursday, and MSCI Asia was up 1.5% today.  Japan, Australia, and Korea markets outperformed, while India and China underperformed with only small gains on the day.  European markets are higher so far today, helped by strong European data (see below) with Euro Stoxx 50 up 0.4% so far.  Futures markets are currently pointing to a flat open for US equity markets today.     

US bond market is softer but likely to hang on to recent gains as US growth outlook remains in question.  Japan bond market was lower as 10-year yields rose 1 bp, while European bond markets are mixed, as 10-year yields in UK, France, and Germany are up 8 bp, flat, and up 4 bp, respectively.  Greek 10-year yields are down 5 bp, Portugal up 1 bp, Ireland flat, Italy down 1 bp, and Spain down 1 bp.

Currency Markets

It would be an understatement to say that results of the European bank stress tests are the major event today.  We got some more leaks yesterday, when it was reported that two large Irish banks had passed the tests. Key points to look for when results are released at are what assumption were made regarding the “adverse” and “sovereign shock” scenarios, and what these imply for the amount of capital that needs to be raised.  Again, if the assumptions are not rigorous enough, having virtually every bank get a passing grade will not do much for credibility.  And remember, failure doesn’t mean the bank is insolvent, but simply means that its capital cushion falls short of what is considered prudent under the stress scenarios.  Market contacts suggest that a number as high as USD100 bln for need to raise capital would be acceptable to the markets. Anything too low and markets will question the stress assumptions, while anything too high and concerns about the banking sector will pick up again.  It’s a delicate balancing act.  For now, markets seem to be pricing in a middle of the road outcome.  The fact that the results are being released after European markets close on a summer Friday does make us a bit nervous, and we are concerned about outsized movements in thin markets.        
Markets continue to react favorably to strong earnings in the US and robust economic data from Europe.  European data reported today was again mostly stronger than expected.  German IFO for July came in at 106.2 vs. 101.5 expected and 101.8 in June.  This is the highest since mid-2007.  The expectations component jumped to 105.5 from a revised 102.5 (was 102.4) in June, and this is the highest since October 1994!  This component got as high as 105.4 back in 2006 and the sharp recovery from the December 2008 low of 76.7 has been stunning.  Meanwhile, UK Q2 GDP rose 1.1% q/q vs. expected 0.6% and 0.3% in Q1, while the y/y rate was 1.6% vs. -0.2% in Q1 and the first positive reading since Q2 08.  With good news on both fronts, we note that for now, sterling has the upper hand as EUR/GBP is testing this week’s low around .8380.  Break of this would set up a test of the .8300 level near-term.  While yesterday’s US data came in mostly better than expected, it was not enough to change the dynamics in play regarding US vs. European growth.  The euro continues to bounce from the mid-week low just above 1.27 and looks on track to retest the 1.30 area.  Today, no US data is scheduled for release, and we note again that there is not much on the data side to disperse the gloom surrounding the US economic outlook until July jobs report due out August 6.  It’s too early to get a read on market expectations for this important number, but it’s really the next potential flashpoint for the US outlook.   

Moody’s put Hungary’s Baa1 rating on review for possible downgrade.  Agency said that negotiations with the IMF over a new program is a key rating consideration.  So much for Hungary’s wishful thinking that it can go without IMF help.  Hungarian bonds and CDSs reacted negatively to the news, and while this should serve as a wake-up call to the government, we do not expect a quick agreement with the IMF.  Moody’s said the review would last 4 months, and so we note that this gives Hungary very little leeway if it tries to hold out until after October local elections to strike a deal with the IMF.  S&P and Fitch are lower at BBB- and BBB, respectively.  S&P is closest to our own sovereign model rating of BB+/Ba1/BB+, while Moody’s is most out of line.  If IMF talks drag on as we suspect, we would expect Moody’s to downgrade its Baa1 rating and we cannot rule out others moving as well.  Junk status is a real possibility for Hungary.  In our view, a delay until the autumn would be taken very negatively by the markets.  We went short HUF vs. EUR last week around 280 for a move back to the late June high of 288 and then the early June high of 290.50.  Those targets were met, but then the forint has since rallied along with the rest of EM.   EUR/HUF jumped about 1% on the Moody’s news, and we think there is scope to test the 292 high from this week and then the 300 level in the coming weeks. 

Even as the yen softens a bit, Japan officials are expressing displeasure for the third straight day.  This time, National Strategy Minister Satoshi Arai and Cabinet Office official Keisuke Tsumura complained about the strong yen.  Earlier this week, it was Vice Finance Minister Ikeda and Trade Minister Naoshima warning that the strong yen posed a threat to Japan’s recovery.  USD/JPY is seeing a muted bounce after this week testing the year’s low just above 86, but further yen gains seem likely if global concerns heat up again as we expect.  After the 86 area, next target is the Nov 09 low around 85.  As we noted yesterday, we expect further pressure will be brought to bear on the BOJ to take additional measures to try and help offset the headwinds from a stronger yen, including increasing its JGB purchases which currently stand at JPY1.8 trln per month.  However, we continue to downplay the risk of BOJ intervention to weaken the yen.

Upcoming Economic Releases

Canada CPI for June due out 7:00 EST/11:00 GMT and expected to be flat m/m after rising 0.3% m/m in May.  Core CPI expected to rise 0.1% m/m after rising 0.3% m/m in May.  At 10:00 EST/14:00 GMT, Mexico June trade due out and $100 mln surplus expected vs. $179 mln in May.  No US speakers of note.  At 12:00 EST/16:00 GMT, European bank stress test results are due out.