Safe Haven Trades Dominate

BBH CurrencyView

• Sentiment remains poor after S&P downgrade; equities; safe haven trades to remain in vogue
• Euro zone to remain under pressure despite ECB purchases of Italian and Spanish bonds
• G7, G20, EU, and ECB weekend meetings have done little to improve sentiment; EM FX weaker

Negative sentiment continues following the US downgrade and despite ECB support of Spanish and Italian bonds. The dollar is mixed in its classic risk aversion pattern, weakening around 1% against CHF and JPY but strengthening against most other currencies. EUR/USD dropped to 1.4260 from trading over 1.44 earlier today. Similarly, European stock indices opened higher, supported by a strong performance in the financial sector, but they have since reversed those gains and are now down as much as 3%. US futures are pointing to a 2.7% lower open. In fixed income markets, UST yields are lower by 4-8 bp across the curve. In Europe, periphery yields are down sharply on the back of ECB buying. In the 10-year sector, Italian and Spanish bonds yields are down 75 and 83 bp, while falling 19 bp in Greece and 9 bp in Ireland. Energy futures are sharply lower, falling as much as 4% while gold reached a new record and is now at 1705 $/oz. EM FX and equities are largely weaker.

After US downgrade, others stand out as likely candidates too. We have long advocated downgrades for much of the periphery, but the US move takes us outside of that and into “core” countries. As we’ve noted before, France has slipped into borderline AA+/Aa1/AA+ territory, so risks to its AAA are rising as stresses spread. Belgium has a clear case for a downgrade, as our model rating of AA/Aa2/AA is firmly below actual ratings of AA+/Aa1/AA+. Lest we appear to be picking on the euro zone, we note that our model is showing downgrades for UK (AA/Aa2/AA implied vs. AAA/Aaa/AAA actual) and Japan (A+/A1/A+ implied vs. AA-/Aa2/AA actual). We are, however, surprised that Moody’s cited the failed intervention as a negative factor on Japan’s rating.

FOMC meeting this Tuesday has taken on more significance. While July jobs data was slightly stronger than expected, it was not enough to shift market expectations for some sort of action from the Fed. We have argued that the bar to QE3 is high and we believe it remains high. Fed Chairman Bernanke outlined four policy options back in April. The Fed could purchase more assets. It could structure its balance sheet differently, which seemed to hint at increasing the average maturity of its holdings. It could cut the rate on excess reserves. Finally, it could provide more guidance to keeping rates low for a long term, which could include the period it reinvests the MBS proceeds into Treasuries. We think that the Fed will respond to evidence of a slowing of the U.S. economy. It will likely downgrade its assessment of the economy and lower its GDP forecasts for this year and next. However, we expect the policy response to take the form of explicit language assuring investors that rate changes will not be forthcoming and may even define a period. The Fed is also likely to extend their securities portfolio from shorter maturities to longer maturities, with the intention of inducing a flatter yield curve. It is possible that the Fed also announces an explicit yield target for specific maturities. We do not expect the Fed to renew its Treasury buying operation (QEIII) or to buy non-government obligations (such as corporate bonds or equities), as some have suggested.

This week sees other important events. Spain is likely to announce new budget savings and economic reforms, while Berlusconi has extended Italy’s parliament for a new austerity measures vote. We do not think that ECB buying Italian and Spanish bonds is a game-changer, since ECB purchases have not lowered Greek, Irish or Portuguese yields. Indeed, press reports that the ECB decision to buy those bonds was not unanimous will undermine its efforts, as will the German government’s admission that nothing new policy-wise is planned beyond what was announced after the July EU summit. In the UK, BOE’s King is likely to announce a cut in its GDP forecast on Wednesday from 1.8%, and will surely start tongues wagging about a new round of asset purchases by BOE. Taken in tandem with heightened UK downgrade risk, we think GBP outperformance is unlikely to be sustained. For now, we favor the safe haven plays in CHF and JPY.

In this current environment, EM equities and FX will be dragged down. It is not surprising, then, that the focus and rhetoric in many EM countries has shifted towards containing the risks of depreciation. Overnight, we have seen more concrete comments to this effect by officials in Turkey, Korea, and Taiwan, along with calming words from officials in other EM countries. We think Asia and Latam will outperform, while EMEA is likely to underperform. Decoupling from DM is still a ways off.