BBH CurrencyView
- Safe havens continue trade on the back foot as risk appetite resurgences; European stocks up over 1%
- Euro trades above $1.42 ahead of tomorrow’s summit; EZ summit likely to address two key issues
- Brazil’s central bank expected to deliver a 25bps hike; CEE currencies most vulnerable to EZ stress
Markets continue to hold recent ranges as investors await a resolution of the US debt impasse and the results from the EU summit tomorrow. The euro made another attempt at the $1.42 mark following an FT Deutschland article overnight noting that the EU are considering solutions that could prove scalable with respect to Italy and Spain. The discussions have triggered a sharp exodus from haven flows, with Bunds and Gilt futures down 67bps and 44bps at 128.36 and 122.89 respectively, which has lifted market sentiment for a second straight day. European equity markets have rallied, with the Euro Stoxx 50 up 1%, led by financials (+2.4%). Scandies continue to outperform on the improvement of global risk sentiment, with CAD and AUD also firmer as commodities advance. Cable is lagging behind on the crosses on unwinding of the earlier euro-crisis led bid, which has outweighed the effects of the less dovish then expected BoE MPC minutes. Oil prices remain firm, up over 1.2%.
Over the past two days the euro has begun to trade as if a successful deal will come to fruition tomorrow, with the euro advancing 1.2% against the CHF and 0.7% against the USD. It is wise to be cautious about expecting a grand bargain that is likely to ‘solve’ the crisis, a view that was confirmed by Germany’s Angela Merkel yesterday. Nevertheless, while the event is unlikely to be a panacea for all of Europe’s debt problems, money markets and options pricing over the past two days are beginning to show an easing in tensions. Euro basis swaps (the basis point premium paid in the interbank market to swap euro’s for dollar) continue to narrow, with the 1-year swap falling back to 30bps after reaching a peak of roughly 34bps over a week ago. The price of 10-delta butterfly options (which measure tail-risk protection) contracted by 6% over past few days after reaching yearly highs just a few days ago. With the likelihood of grand bargain negligible, the summit is expected to address two important questions that will help shape the tone of market sentiment over the coming weeks. One, how to fund the second Greek aid pack and equally important the role of private sector involvement. Two, with the flare-up in Spanish and Italian yields the market is likely to be looking for an answer in order to reduce contagion risk. In order to deal with possible contagion risks, in our view, policy makers are likely to focus on increasing the size and flexibility of the EFSF. Local press reports indicate that one option being discussed would be to allow the EFSF to provide short-term credit lines to countries needing assistance, which is not possible at the moment as countries need to agree to an adjustment program before acquiring funds. Likewise, discussions are likely to focus on the bond buyback scheme, which would essentially allow the EFSF to buy bonds in the secondary market or allow for the EFSF to loan Greece the money to use it to buy back its debt at a discount to market prices in order to reduce the overall principal. Altogether, an agreement that eases market tensions is likely to lead to a sharp selloff in bunds and re-widening of the 2-year German-US yield spread off the back of sluggish US data and lead the euro to test the 100-dma just above $1.43.
Brazil’s central bank is expected to deliver a 25 bp rate hike today to 12.5%, which is almost certain and a follow up hike in September. Of course it will depend on incoming data, but it is a strong possibility in our view. Indeed, the prospects of even greater carry for BRL is likely the major reason it has rolled out new FX measures recently, in effect front-running the likely BRL appreciation that’s to come. Implied yield on the 1-month BRL NDF rose to almost 10%, highest it’s been since mid-March. Even more FX measures will still come on a move towards 1.50, but can only slow the appreciation trend, not reverse it. Price pressures remain high, confirmed by today’s CPI figures. Market sees a year-end SELIC rate of 12.75%, but we think the risk is to the upside given strong momentum in the economy. Weak IP data from Poland released Tuesday justifies NBP dovishness. Poland is less exposed to trade and the euro zone than some of its neighbors, with exports/GDP running around 33% along with a decent-sized domestic market. The ones that are really vulnerable to stresses in the euro zone are Czech and Hungary, both with exports/GDP close to 75%. As a point of reference, it’s worth noting that Brazil’s ratio is 10%. It supports our view that Brazil should not be so obsessed with the exchange rate given the relative size of its export sector, but it is widely acknowledged that the manufacturing lobby is very strong and perhaps has a bigger voice than its relative importance justifies.