Irish Bailout is Confirmed, Euro Bids Higher

Highlights
The US dollar is trading broadly lower as the details of the Irish bailout emerge with Ireland seeking around €95bln in aid. The euro is up versus the greenback after making an early high of $1.378 but subsequent gains were stymied by sovereign account, along with option related selling around $1.38. Sterling participated in the early morning rally as well; nearly reaching the $1.61 level but fell back as investors remain skeptical over the rest of the periphery.  The dollar is flat versus the yen as the market continues to trade sideways.  Elsewhere, the unexpected downgrade in New Zealand ratings outlook by S&P, from stable to negative, saw the New Zealand dollar take a hit, so some follow-through could be seen in the days ahead.  The New Zealand dollar is, in fact, the weakest performer in the G10. 

Global equity markets are mostly up, led by a strong performance in Asia, with the details of the Irish bailout emerging.  The MSCI Asia index is up 0.7% with positive gains in the Nikkei and but mixed returns in the Shanghai. The 0.9% gain in the Nikkei is led by outperformance in energy and technology with a 1% loss in financial weighing on the Shanghai.  In Europe stocks were buoyed by the news of the Irish bailout with the Euro Stoxx 600 up 0.3% led by gains in consumer goods.  Meanwhile, the Dax and FTSE were both up 0.4% and 0.3% respectively with gains in consumers and health care.

European sovereign bonds yields continued to moderate on the back of the Irish bailout news yet the focus is already starting to shift on the other vulnerable countries as Portugal’s 10-year increased by 4bp.   On the other hand Irish 10-year yields are down 24bp along with a 5bp decline in the Italian 10-year.  In addition, Greek 10-year yields are up 12bp, the most since early September.  Meanwhile, following a €2.9bln auction of zero coupon 12-month bills 10-year German yields are down 2bp with the 10-year and 2-year US Treasury flat. 

Currency Markets

Ireland becomes second eurozone country to need a rescue and draw on the €750bln emergency fund, set up by the EU and the IMF in May as part of the Greek bailout. The U.K. and Sweden may contribute bilateral loans, and the total package is likely to be around €95bln, with Finance Minister Lenihan only saying it will be less than €100bln. Ireland will channel some of the money to lenders through a contingent capital fund, and the problem of Ireland’s banks is indeed what brought Ireland down in the end.  As many are aware the Irish government is fully funded until the middle of 2011 with an estimated €20bln in reserves set aside but the markets focused on Ireland as its bank found it increasingly more difficult to access the capital markets.  Officials had been pushing Ireland to ask for a deal in order to calm markets as talks about a permanent rescue mechanism continue and the Irish bailout will make it easier for Germany to push through demands for investor participation in future bailouts.

Indeed Eurogroup head Juncker said today that the private sector should be held liable if it had a role in the crisis, although he argued against an ex ante inclusion of the private sector, as Germany is asking for. Markets have reacted positive thus far with the euro making a new leg up.  But with Ireland receiving funds, the focus is likely to merely switch to other vulnerable countries, with Portugal next on the list.  Today’s fixed income price action was a clearly demonstration of the markets renewed focus on the other peripheral countries.  Officials are eager to stress that Portugal is different from Ireland, but they said that Ireland was different from Greece, which it is, but still needed a bailout to support its ailing banking system.  In addition with Irish politicians insisting as recently as last week, that a bailout is not on the cards, markets have not much reason to believe official statements.  The markets have been buying the euro on the rumor of a bailout of Ireland but we feel any euro strength will be short-lived.  In our view the euro is most likely set to test the $1.40 level again but with waning support from market sentiment and interest rates that any strength is unlikely to last. 

Market is expecting more tightening measures from China this week.  We would not be surprised to see this, as we have predicted a combination of rate hikes, reserve requirement hikes, and currency strength in the next year in the PBOC’s efforts to rein in inflation.  What is not helpful to the debate was comments by central bank adviser Li Daokui, who said China can consider selling USTs in response to the Fed’s decision to enact QEII.   He added that policy-makers could look for others means of "compensation" for losses China may suffer from QEII.  China is in no position to start dumping its holdings of USTs, nor should it even talk about it since that could cause more harm to China than anything coming from QEII.  If QEII is anything like QEI, most of the money will end up sitting on the Fed’s balance sheet as excess reserves. We continue to believe that flows into EM are simply reflecting a reallocation of the existing global portfolio into EM.

S&P lowered New Zealand AA+ rating outlook to negative, noting that "The main risk to the ratings would be a significant weakening in the credit quality of New Zealand’s banking sector."  Move took the markets (and us) by surprise.  Our sovereign ratings model puts New Zealand at AAA/Aaa/AAA vs. actual ratings of AA+/Aaa/AA+, with a score just below Australia (which has actual and implied ratings of AAA/Aaa/AAA).  We do not think a downgrade is justified, but the focus on the banking sector suggests that ratings agencies are being extra sensitive in the wake of developments in Ireland.  S&P also noted that the current account gap is widening significantly to an average 5.9% of GDP over the next three years, leading to higher external financing needs ahead.   Note that Moody’s said that the multi-notch downgrade for Ireland is likely.  Our sovereign ratings model now puts Ireland at BBB/Baa/BBB vs. actual ratings of AA-/Aa2/A.  Clearly, multi-notch downgrades for Ireland are warranted.       

Upcoming Economic Releases

At 08:30 EST / 12:30 GMT the US reports the Chicago Fed Nat Activity index which is expected to increase to -0.24 from -0.58.  Meanwhile, at 10:00 EST / 14:00 GMT Mexico reports 3Q GDP and its Global Economic Indicator, both of which are expected to fall. Events: Fed’s Kocherlakota (FOMC non-voter) speaks at 1:30 PM.