Downgrades and Defaults

BBH CurrencyView

• EUR/USD and European stocks recover amid hopes of Greece aid; market shrugs off Italy’s downgrade
• BBH Sovereign Credit Rating Model suggests that further downgrades for Italy and Spain are likely
• Turkey’s central bank leaves its benchmark rate at 5.75%; Hungary likely to remain on hold as well

European markets reversed opening losses after the overnight downgrade of Italy from S&P and fears that Chinese banks are cutting credit lines to European counterparties. Greece made a €769m bond coupon payment which helped quell market fears speculation about a Greek referendum on exiting the euro area. The Euro Stoxx 50 is up 1.7% through the morning session, though financials continue to lag behind (+0.6%). A more constructive tone in Europe has also helped lift US benchmark equity futures ahead of the open with the Dow Dec’11 up 85 and the S&P 500 +9.1. Core government bonds are trading little changed with the US 10yr +2bps at 1.97% and Germany 10yr yields holding steady at 1.79%. The cost of Italian 5yr default insurance rose to a new record high above 500 today.

There is lots of negative European news for markets to digest again this morning, beginning with the Italian credit downgrade, a lukewarm Spanish bill auction and a German ZEW survey at its lowest level since 2008 and consistent with negative German GDP growth. And yet the EUR/USD is marginally firmer amid the hopes that today’s phone call between Greece and the Troika will result in Greece getting its next €8bln aid tranche, while rumors that Greece is considering a referendum on EMU membership have also been denied by local officials. And while the results of this phone call also likely to be the key event of the day, we continue to suspect that the rapid deterioration in EZ economic data and the potential for higher borrowing costs due in part to rating downgrades as likely to be major headwinds for the EUR/USD moving forward. After all, the key ingredient that appears to be absent from many of the talks and solutions about how to mitigate the EZ sovereign debt is economic growth, which is unlikely given tough packages implemented by many of the periphery countries. At the same time, according to the BBH Credit Rating Model, S&P’s move to A is generally in line with the output from our model, while Moody’s (Aa2) and Fitch (AA-) are still off by 3-4 notches. What’s more, Spain is also way out of line too at AA/Aa2/AA+ compared to our ratings of A-/A3/A-. To us, that raises the possibility that other rating agencies will in time cut Italy as well, while a Spanish rating cut would not be too far behind, given the recent reports that show problems on the regional level as well. Taken together, the potential for Greece to again avoid a default, along with the sharp adjustments in positioning data (CFTC speculative contracts show the market is now short the equivalent of $10bln) suggest that a euro short-covering may lead the EUR/USD to consolidate some of its recent losses, with a test near the 5dma (1.376). Elsewhere, Swiss trade data revealed a notable drop in exports, to CHF13,885mln from CHF16,621mln in July. On balance, the combination of the strong CHF and a slowdown in global conditions, particularly in the EZ, has indeed begun to impact Switzerland’s trade performance. The data underscores the reasons behind for the SNB’s drastic action to peg the CHF to the EUR in order to deals with its massive overvaluation.

In the EM space, interest rate decisions by Hungary are expected to be among the key data reports this morning. In Hungary, the biggest concern for policymakers is the threat to financial stability posed by a weaker forint. We expect the Hungarian Monetary Council will leave rates unchanged at 6.0%. Meanwhile, with inflation expected to move closer in line with the central bank’s 3% y/y target over the coming months some observers have suggested that the next move for the Monetary Council would be a potential series of two 25bps cuts to support economic growth. But with the forint now trading at its weakest level against the euro for 14 months, any move in the next three months is far more likely to be up than down amid the potential for higher inflation off the back of weak exchange rate. Taken together, the chance of a defensive rate hike of 50bps or so at today’s MPC is expected to be high but we still maintain our view that the Monetary Council will remain in wait-and-see mode, while HUF is likely to remain vulnerable to the ongoing financial stress. In Brazil, the weekly central bank survey shows continued deterioration in inflation expectations. Weaker BRL and higher import tariffs will end up injecting more inflation into the economy, and we can see this thing really going off the rails if inflation gets out of hand. Lower nominal yields plus higher inflation will not instill investor with confidence, and will most likely lead to higher borrowing costs for the government. Inflation data out today is likely to signal that the rate cut was unjustified but markets nevertheless continue to price in the potential for 75bps cuts at both the Oct/Nov meetings.