Euro Testing May 10 High, Helped By Strong Euro Zone Sentiment Survey

From the BBH Currency Strategy Team.

Highlights

US dollar is weaker across the board vs. the majors as sentiment appears to be improving today after a consolidative day yesterday.  Risk on FX trading appears to be back on track after taking a brief breather.  The euro has so far been unable to break the May 10 high around 1.31 against the dollar, but its upside move remains intact (see below).  EM FX is mostly stronger, with HUF the best of the lot as sentiment improves and debt sale went fine.  Biggest gainers on the day so far vs. USD are CHF, AUD, NOK, HUF, and SEK, while the only loser vs. USD so far today is KRW.  EM sentiment will likely be boosted by IMF approving new $15.2 bln program for Ukraine.  Also, Turkish central bank started the normalization process for policy by raising the foreign currency reserve requirement for commercial banks by 50 bp to 10%.   Brazil central bank minutes due out today should help shine a light on the future interest rate outlook.

Asian markets were modestly higher, with MSCI Asia Pacific up 0.4% today.  Indonesia and China markets outperformed, while Japan, Korea, and Australia markets underperformed and were down on the day.  European markets are up so far today, with Euro Stoxx 50 rising 0.6%.  Futures markets are currently pointing to a flat open for US equity markets today.     

US bond market is mixed.  Global risk sentiment has come back but is being offset by weak US growth outlook.  Japan bond market was higher as 10-year yields were down 1 bp today, while European bond markets are mostly higher as 10-year yields in UK, France, and Germany are down 4 bp, 2 bp, and 2 bp, respectively.  Greek 10-year yields are down 4 bp, Portugal flat, Ireland up 5 bp, Italy flat, and Spain up 1 bp.  Hungarian debt auction went well with strong demand seen, but borrowing costs remain high.

Currency Markets

The euro is making new highs for the cycle against the dollar even as stresses in the European banking sector remain. The post-ESFS high from May 10 at around 1.3090 is being tested today, and improved sentiment suggests this level will eventually give way.  Peripheral bond spreads continue to narrow, but we note that 3-month EURIBOR continues to creep higher and was fixed today at another new high for this cycle and at its highest level (.833%) since the summer of 2009.  EURIBOR rates have been rising steadily since April, due in large part to perceived jump in counterparty risk.  Given the continued spread tightening in the periphery, the upside for the euro is likely to remain intact for now.  From a technical standpoint, clean break of 1.30 was the final 62% retracement level of the euro’s April-June drop, and points to a test of the April high around 1.3700.  Intermediate support seen around the 1.33 area.

Euro zone and UK economic releases were mixed today.  Data surprises have swung sharply in favor of the euro and away from the dollar in recent weeks. Indeed, that has been one of the factors behind the euro’s recovery.  However, we note that this “surprise difference” appears to be mean-reverting, and rarely stays at historical extremes for very long.  As such, we would expect this difference to ease in the coming weeks.  This would also fit into our belief that this euro rally remains a corrective move.  Perhaps as the economic surprise factor moves away from favoring the euro, that would also coincide with some eventual topping action for the euro. 

For now, though, the market remains pessimistic on the US, and the Fed Beige book didn’t help.  The latest one released yesterday highlighted a further slowdown in most of the 12 Fed districts in July compared to the survey conducted in early June.  It noted that economic activity is still growing on balance across the 12 Fed districts, but there appear to be very few areas of strength.  This really gives no indication the slowdown which began in May is ending, and so the Fed may take a slightly more dovish tone at its upcoming August 10 meeting.  Germany’s July unemployment saw a 20k monthly decline, which added to a revised 20k (was 21k) fall in June and represents the 13th consecutive month of decline, while the unemployment rate fell to 7.6% from 7.7%.  Meanwhile, a further marginal improvement in the euro zone economy was captured by the EC July economic sentiment index, which rose to 101.3 vs. an expected 99.1 from a revised 99 (was 98.7). This was the highest since March 208.  In the UK, the July house prices reported at a weaker than expected -0.5% m/m (following a flat outcome previously), for a yearly rate decelerating sharply (to 6.6% from 8.7%).  Given the slight divergence in data, it’s not too surprising that EUR/GBP is higher on the day so far, but sterling bulls should use this opportunity to go long for a move back to late June low around .8070.  Initial retracement targets are .8300 and .8250. 

The RBNZ hiked rates 25 bp to 3% late yesterday, as expected.  Despite being only the second hike in the current tightening cycle, the RBNZ sounded a dovish note and said that the pace of future hikes may be more moderate than was projected in its June statement.  Gov Bollard noted that the outlook for NZ growth has softened somewhat, but that it is still appropriate to remove accommodative policy.  He added that future prospects for growth had deteriorated, and that recent NZD gains are inconsistent with this as well as the decline in NZ export prices.  On the domestic front, a soft housing sector and associated negative wealth effects and continued uncertainties about the economy have set a more cautious mood among consumers of late. The consumer confidence index fell to an 11 month low in July, capturing this more hesitant environment. Planned income tax cuts should help restore confidence in the autumn but is not an all clear for the consumer sector at this point.  As such, we tend to agree with the RBNZ that the economic case for aggressive rate hikes is not all that strong and so we believe that a pause in the tightening cycle may be seen before the end of the year.  All this means that notwithstanding the recent pause in the RBA’s tightening cycle, the yield advantage will continue to favor AUD over NZD. While AUD/NZD has been fairly stable within a 1.2100-1.2350 trading range over the past couple of weeks, Aussie bulls should not worry too much.  Next RBNZ meeting is September 16 (September 15 for US investors).  Prior to this statement, market was pricing in about 25 bp of tightening per quarter, but those expectations will likely be pared back further.  OIS market is already signaling a slightly less aggressive outlook for NZ rates.  While RBA rate hike talk has been quieted by the softer than expected Q2 CPI data, AUD is likely to continue enjoying its comparative yield advantage and growth profile.  After basing around 1.22, this pair should move upwards in the coming weeks.  Indeed, AUD is outperforming NZD today by a wide margin as risk appetite picks up.  NZD/USD has fallen after the announcement, and retracement levels to watch for are .7210 and .7170, break of which would target the July 19 low of .7030.

Upcoming Economic Releases
US weekly jobless claims data due out 8:30 EST/12:30 GMT and expected to fall to 460k from 464k previously.  At 9:30 EST/13:30 GMT, Brazil releases June budget data, and the primary surplus is expected to rise to BRL3.9 bln from BRL1.4 bln.  Fed’s Fisher speaks at 13:20 EST/17:20 GMT.