Euro at the Crossroads

BBH CurrencyView

• Dollar is broadly weaker amid hopes that Greek debt negotiations are very close to agreement
• Asian stocks posted new trend highs, MSCI Asia Pacific up 0.3%; Dow Jones tested highest level since 2008
• EuroStoxx 600 reverses earlier losses and is currently flat on the day; Greek banking shares up nearly 6.0%

The dollar is broadly weaker with European markets holding on to a better risk backdrop following another encouraging Italian auction, along with hopes for a Greek debt deal. However, Portugal and Spain still remain a concern with Portuguese yields (10-year currently at 13.75%) on the rise and Spanish retail sales and unemployment disappointing expectations. In addition, EZ M3 money supply growth decelerated to just 1.6% y/y (below expectations) in December, underscoring expectations for a further monetary easing in H1. The euro, nevertheless, remains supported near 1.3150 heading into the weekend. Near term support seen 1.308. A convincing break to the downside would open a test of 1.288; resistance near 1.32.

Since mid-week, the yen has been the strongest G10 currency, appreciating 1% against the greenback and almost 0.7% against the euro. There appears to be three considerations. First, on Wednesday the dollar tested the 200-day moving average near JPY78.35, which also corresponded to the upper end of a range that has persisted for a couple of months. Technically this appeared to attract dollar sellers. Second, this provided an opportune time for Japanese exporters who are believed to be conducting month-end repatriation. Third, the key fundamental factor is not an intensification of global financial tensions (as illustrated rally in global shares this week and decline in most peripheral European bond markets). Rather the easing of Fed policy and the decline in US yields appears to be the main weight. The lower rates and the ongoing uncertainties shrouding Europe is thought to discourage Japanese investors from buying foreign assets, mostly consists of bonds. This supports the current account balance, despite the shrinking contribution of trade. Dollar support is likely to be seen near the trend off the early Jan and mid-Jan lows, coming in now near JPY76.60. It will take a move back above JPY77.20 to stabilize the tone.

On the data front, many are likely to be focused on the Q4 US GDP report, which is likely to show the faster pace of growth in 2011. The consensus is looking for 3% annualized as a recovery from the weakness of the third quarter is seen. On the one hand, output is likely predominantly driven by consumption, net external trade and inventories, with consumption boosted by the increase in real incomes as abating prices pressures should marginally boost real incomes. On the other hand, the only disappoint is likely to be the potential stagnation in business investment and equipment and software over the last few months of the last year, which may be tempered in part by a more rapid increase in residential investment. Looking ahead, it is likely that US growth is likely to slow from pace seen in Q4 as the impacts from inventory restocking wane, together with slowing exports as global demand loses steam but the US is still likely to grow between 2-2.5% in 2012. Nevertheless, we still expect further evidence of US economic resilience to be supportive of risk appetite in the short turn and in turn would likely benefit CAD and MXN the most due to their high beta status and links to US economic growth.

Elsewhere, the Swiss KOF leading indicator fell again from 0.01 in December to -0.17 in January. This was lower than consensus (-0.10) and a print that takes the index to its lowest level since July 2009. Indeed, this is further evidence that the Swiss economy is likely to contract further over the coming months driven the weakness in export amid the intensification of the EZ debt crisis. In particular, over nearly past year the leading index has lost over 2.5 points, which is consistent with a considerable slowdown in the pace of Swiss economic activity. However, we believe the SNB is likely to keep the EUR/CHF floor at 1.20 in 2012 and looking ahead we do not envision the SNB moving the floor higher.

INR is the distant outperformer in the EM space today, rising 1.5% against the dollar despite the mood of consolidation prevalent in global financial markets. The move was prompted by a combination of factors. First, from a technical perspective, USD/INR finally made a clean break below the 50 level for the first time since last November. Second, flows into equity and bond markets have been very supportive during this period of risk appetite, and helped by prospects of rate cuts by the RBI. Year to date, foreigners have invested $1.56bn in Indian equity markets and bought $3.39bn worth of debt. Lastly, a central bank source allegedly told Reuters that the RBI may intervene in the forward market in addition to its now regular spot interventions. With all this in mind, it is clear to us that any sharp upwards move in USD/INR will be met by strong headwinds from officials, but we are not convinced that the currency will continue to outperform the region for much longer.