ECB in Focus

BBH CurrencyView

• Dollar is little changed ahead of today’s ECB meeting and ADP report; stocks/commodities are steady
• BoE holds steady, ECB is expected to deliver a 25bps rate hike; market focus likely to be on comments
• Brazilian policy makers focus on verbal intervention; Hungary’s economic outlook skewed to downside

Markets are relatively steady after yesterday’s volatile session with the dollar little changed against most major currencies ahead of today ECB meeting. The euro remains in its narrow range, just ahead of the 100-dma at $1.426, after yesterdays 1% decline, with the currency getting very little support from better than expected German IP data. Cable remains soft following the BoE’s widely expected rate decision to leave rates unchanged, while Swissie maintained a supportive tone but was unable to sustain gains following the soft CPI reading with EUR/CHF gaining 0.2%. An upbeat jobs report boosted the AUD, which rallied to $1.07 before stalling out. Global stocks are mostly higher, with Asian stocks advancing near two-month highs, while the Euro Stoxx 600 has climbed for an eight day in nine. Periphery CDS prices remain under pressure with Portugal’s 5-year above 1000bps.

The ECB will mostly likely deliver the 25bps hike expected today, but the focus will be on any clues about future meetings, along with its take on the potential proposals regarding the rollover of Greek government debt. Recall that Trichet has recently suggested that the ECB would be willing to accept Greek debt as collateral as long as one of the ‘major three’ did not classify the roll-over plan as a credit event. Yet, it appears the ECB’s position on this matter will be challenged over time as two of three rating agencies have already suggested that the recent proposals are likely to trigger a selective default. This could mean that the ECB may be forced to soften its stance over eligibility or potentially overlook the rating agencies judgment and continue to accept Greek bonds as collateral anyway. This is likely to be positive for the euro. Meanwhile, there is some speculation that the ECB may widen the rate corridor, by increasing the main rate and leaving the deposit rate unchanged. While we expect the corridor to remain unchanged this would be a dovish response, signaling concerns about the strength of the interbank market. Furthermore, the absence of the phrase “closely monitoring inflation” is also likely to be construed as dovish, which taken together are two potential scenarios that would likely prompt the euro to test levels near $1.42, though these are low probability events.

Arguably, some would question the logic of tightening policy amid the escalating tension in the periphery and the softening of recent economic data. In our view, though, there are still good reasons for the ECB to remain hawkish as policy remains very loose, leading to excess money growth, while spare capacity continues to diminish faster than expected. As a result, monetary data for May suggested that M3 growth continued to accelerate and equally important forward-looking business surveys remain consistent with above-trend growth. This suggests that the EZ’s output gap is closing faster than many suspect. Altogether, we expect today’s hike to lead to a summer lull followed up by another 25bps in Q4 with the ECB rate normalization unlikely to be derailed by the periphery issues. With the OIS market currently pricing in around a 30% chance for a hike in Q4, we suspect that another hike is likely to be supportive of the euro in time as the rates market begins to bring forward its expectations of a move. Indeed, a rate hike today coupled with a favorable backdrop on the outlook for the economy is likely to be supportive euro. All told, a favorable ADP report (in line with consensus or above) is likely to spur risk appetite ahead of NFP and could lift the euro through $1.435 but in the near-term lingering concerns about the periphery could limit gains for the time being.

More verbal intervention out of Brazilian policymakers reinforces our view that the risk-rewords are not supportive of long BRL positions in the very short term. Yesterday it was President Dilma Rousseff’s turn to voice concern over the rapid appreciation of the real. In addition, CB President Tombini made remarks about the need to continue building FX reserves which can be interpreted as the bank’s continued commitment towards intervention. It is still unclear where the new line in the sand is, but it is looking increasingly likely that it is at USD/BRL1.55. Our medium-term view of further BRL appreciation remains intact, but we prefer to watch on the sidelines for now. Turning to Hungary, today’s significantly lower-than-expected industrial production data is in line with our view that the risks to the Hungarian economy are skewed towards the downside. IP fell to 2.6% in May from 9.7% in April. In relative terms, the Hungarian economic recovery seems a lot more dependent on exports, especially to Germany, than other countries in the region. With this in mind, we think that the effects of ECB tightening will be disproportionately felt in Hungary.