A Game of Positions

By BBH FX Strategy Team On Oct 27, 2011

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Global stocks and risk sensitive currencies are up significantly after the 14^th emergency summit
Outcome satisfied downbeat expectations, details remain short; price action reflects positioning
BoJ left rates on hold but expanded asset purchases; RBNZ on hold but outlook remains hawkish

Global stock markets continue to surge after news that European policy makers had forged an agreement at the emergency summit. The outcome of the summit is likely to have satisfied market expectations, which were arguably low ahead of the event. And while we expect this is unlikely to resolve all fundamental challenges that plaque the euro zone we suspect the outcome is enough to support risk appetite amid this recent bout of positions squaring. As a result, EZ spreads have come in sharply, European banking shares are7% higher and the dollar is softer across the board. On the data front, euro zone Economic Confidence fell much less than expected, euro zone M3 money supply growth accelerated more than expected, and the UK CBI Distributive Trades Survey also came in above consensus. German inflation expected to remain unchanged at 0.1% m/m. Elsewhere the Riksbank left the repo rate steady at 2.00% and expects to resume tightening next year.

We believe the outcome from the euro zone Summit produced the best can be expected as policy makers did a good job of downplaying expectations ahead of the event. Above all, we view the subsequent price action as a reflection of positioning rather than euphoria about the resolution of the crisis. Nevertheless, the euro zone’s 14^th summit produced the three pronged plan that includes 50% haircut on Greek debt, a deal on bank recaps and a “top up” in the firepower of the EFSF (along with guarantees which only apply in the event of a default). Greece will also get an additional €100bln in cash, also to finance the recapitalization of banks. Based on initial projections, the haircut should allow Greek debt to be reduced to around 120% of GDP in 2020. The authorities agreed that involvement is voluntary, excluding the default scenario. Meanwhile, the €220bln of the EFSF, that are not already earmarked so far will be leveraged to €1,000bln, through bond insurances and the creation of special purpose vehicles to attract outside investment. China and other cash rich emerging markets have already signaled interest but overall EU leaders expect the EFSF framework to be ready by the end of November. What’s more banks will be required to lift the core capital ratio to 9% by the middle of next year, with estimates suggesting that this will require €106bln of fresh capital. Most banks should be able to handle this but Greek banks in particular this will be difficult, which will put further pressure on the Greek government. Banks have until December 26 to specify details of how they plan to raise additional funds, with national governments and the EFSF the ultimate backstop.

Many questions over the sustainability of the master plan are likely to remain after today. We suspect that while this plan has provided a blueprint that reduces the tail risk of banking crisis in Europe (and limits global contagion) we doubt this is the end of the crisis and doubt this is likely enough to bring medium-term support for the euro. First, the debt reduction for Greece is still insufficient to alleviate Greece from its “debt trap.” Next, will Italy deliver measures to boost growth and reduce its deficit? More importantly, the plan does not address structural problems in the euro zone to that would improve growth prospects for region as a whole. In the near-term, though, we do see this plan as broadly positive for risk appetite and coupled with the recent upsides surprises in US data and the potential for more accommodative policy from China this could see growth sensitive currencies (CAD, AUD, NZD, SEK, NOK) extend their recent rally, even though we expect that the risks to the euro from here are to the downside ahead of the 200dma (1.409). At the same time if today’s Q3 US GDP report delivers a strong result it has a chance of taking the S&P and risk sensitive currencies with it. AUD in particular should thrive on this news despite the potential for a rate cut, given the market has already discounted nearly four 25bps rate cuts from the RBA over the next year.

In Asia the BoJ expanded asset purchases by ¥5tln to ¥20tln and left its key rate unchanged at 0.1%, which was in line with expectations. Japanese policy makers will await the reaction from the euro zone news and hope it reduces yen inflows and the demand for safe havens. Japanese intervention rhetoric picked up significantly this week, yet the MoF have held fire ahead of the EU summit and BoJ meeting. They may decide to bring back the yen issue back to the G20 meeting next week, though Finance Minister Azumi already warned that the G20 communiqué did not prevent it from acting unilaterally. The RBNZ kept rates steady at 2.50%, matching expectations, but delivered a somewhat hawkish statement. While domestic growth continues to expand at a modest pace, the RBNZ continues to expect the Christchurch rebuilding efforts to provide significant support to the economy and likely to prompt the need to move rates higher. Nevertheless, a move higher is likely conditional upon global developments and on this front it appears the scope for a hike is improving.