Dollar and Yen Advance, SNB Challenged

BBH CurrencyView

The US dollar remains broadly firmer as euro zone concerns pressure below the surface. The rise in periphery yields continue to drive the euro lower. Spain’s 10-year yield is up 12 bp to 5.77% and the Spanish-German 10-year spread reached 400 bp for the first time since December. At this morning’s auction, France saw its borrowing costs rise for the majority of the debt sold. The euro is down against the dollar for the fourth day in a row, currently down 0.6% to 1.307. Support still expected at the bottom end of the recent range near 1.30. Increased euro zone tensions encouraged the market to test the SNB’s resolve at capping the franc against the euro. The BOE left policy unchanged, as expected. UK data was mixed, as February industrial production rose 0.4% m/m (in line with consensus) but manufacturing unexpectedly declined 1.0% m/m (vs. +0.1% consensus). The weakness in real activity underscores the divergence between the survey measures and economic activity. The dollar is falling against the yen for the second day in a row, down to 81.91. Support expected to come in at 81.00. The yen’s strength weighed on local shares prices and the Nikkei declined 0.5%. Other Asian stocks were mixed, with the MSCI Asia Pacific index flat. European shares are lower for a third day. EuroStoxx 600 is down -0.8%.

Rarely does the turn of the calendar mark a turn in the markets, but there has been a notable shift here as Q2 begins. The contrast between the US and the euro zone was driven home by the less dovish thrust of the FOMC and the continued expansion indicated by the ISM reports. Whereas the US economy may have expanded around 2% at an annualized rate in Q1, the euro zone economy likely contracted. Germany industrial orders and output warns that it is struggling, with the latter now down on a year-over-year basis. The unresolved nature of the European debt crisis also rose in significance as Spanish bond yields have now returned to levels seen around the time of the first LTRO, despite what has been advertized as the most austere budget since Franco. Italy’s 10-year benchmark yield is back to 5.50%, which completely unwinds the March rally. That this back up in yields comes within days of the European finance ministers’ agreement to increase the firewall must be particularly disappointing to officials. Moreover, the heightened tension is also evident at the very heart of the core with the French premium over Germany widening to 125 bp, which has not been seen since late January. The shifting perceptions about the odds of QE3 in the US and relatively constructive data contrast to Europe’s mostly disappointing reports. Not unrelated, a flare of up in tensions in the euro zone have seen the US-German 2-year spread move to a new wide since mid-2010 and the 10-year differential move to its widest level since early 2011.

The increased tensions in the euro zone have encouraged players to test the resolve of the Swiss National Bank to defend the CHF1.20 level. It may have been the higher-than-expected Swiss inflation data that provided the spark. Swiss CPI rose 0.6% in March, compared with a 0.4% consensus forecast and a 0.3% gain in February. While it is true that in the past price pressures did end SNB efforts to prevent franc strength, that is most certainly not the case now. The central bank and private sector KOF expect deflation to persist this year, with 2012 inflation expected to be -0.4%-0.6%. There is some debate whether the market actually traded below CHF1.20, though the central bank has made its intentions known. Thus far, it appears that the SNB’s attempt to prevent the franc’s appreciation has been fairly successful and relatively cheap. Ironically, the SNB’s intervention to buy euros and sell francs may actually add to the pressure on the euro since it recycles the intervention proceeds. Market talk suggests large leveraged accounts joined the SNB on the cross.

March CPI for Brazil will be released this morning amid growing uncertainty about extent of monetary policy easing and confusion about recent currency moves. Forecasts are centered at a 5.4% y/y rate, down from 5.85% in February. CPI has been falling since its recent high of 7.31% in September, but inflation expectations have been ticking higher recently. Expectations for CPI 12-months forward have increased from 5.28% in late February to 5.40%, according to the last official survey. Markets have fully priced in a 75bp cut in the SELIC rate for the mid-April meeting, but rates are now pointing to the risk of even deeper cuts. We prefer to fade recent calls for rates to fall below 9.00%. Our interpretation of official communication suggests that the increased size of cuts is intended to frontload easing rather than deepen the cycle. USD/BRL has been relatively stable over the last couple of sessions, despite the heightened volatility in global FX markets. One explanation is that the level of interference in FX markets by the government has led to a reduced interest in BRL trading. Even if so, we expect this condition to prove temporary as medium-term investors are sure to be once again tempted by the high carry in BRL and reduced volatility. In the short term, however, we think the risk of a spike higher in USD/BRL towards the 1.85 level is more likely than a break below of the 1.80 level.