Is the Euro Zone Debt Crisis Sapping Economic Growth?

BBH CurrencyView

• Dollar firmer across the board amid month end repositioning; US futures suggest modest decline
• Markets likely to remain sensitive to DM economic data; Case-Shiller & FOMC minutes are key today
• EM continues trade directionless for now as investors remain in wait and see mode to assess outlook

The dollar is paring back some of its recent loses off the back of month end positioning and some pullback in risk appetite as markets brace for important data reports this week. Asia stocks posted healthy gains after taking their cue from Wall Street driven in part by encouraging US data and news in the Greek banking sector. European stocks, though, are mixed with the FTSE playing catch-up from yesterday’s holiday and the German Dax down 0.8% driven in part by the slump in EZ confidence. US future suggest a modest decline at the open The euro, meanwhile, is trending lower after breaching 1.45 likely driven by dollar positioning demand and the pullback in EZ confidence. In fact, data out of Europe highlighted falling confidence in the EZ, while U.K. data included a plunge in confidence in the service sector and very weak consumer credit. The Italian bond auction saw satisfactory results, while falling yields suggested ECB’s efforts in the secondary market were having an impact. Noda received backing in Japan.

Price action today and for the most part of this are likely to be dominated by developed market economic data and especially the outlook for US payrolls this week. We continue to expect FX markets to take their cue from the response to economic reports and in turn expect recent trends in positioning data to drive currencies. On balance, despite some of their recent gains market sentiment continues to remain largely bearish for the growth-sensitive currencies in the G10. In fact, looking at the recent adjustment in futures, options and technicals (short-term moving averages relative to spot) the market is still positioned for declines in the EUR, NZD, AUD and to a lesser degree CAD, while short-trends in sentiment and positioning has largely favored long CHF and more surprisingly GBP. Some observers would suggest that despite the upbeat news flow over the past couple of days many are still concerned about the ongoing EZ sovereign debt crisis (which are leading some to expect a recession in the EZ) and potential for stall-speed in the US to morph into a double-dip (not our base case). The raft of weak hard and soft data responses in the EZ support the former, with today’s slump in EZ August confidence numbers the most since December 2008 corroborating this view, while the flow of “hard” data surprises continue to remain supportive of tepid (albeit positive) Q3 growth in the US. Furthermore, EU Commissioner Rehn has offered notable guidance, indicating the EZ sovereign banking crisis and banking system problems are feeding off each other and thus leading to a tightening of financial conditions. So it is not surprising if markets may be taking the recent news flow with a pinch of proverbial salt. Therefore against this backdrop we continue to caution against jumping back into the “oversold” growth sensitive currencies, while negative deposit rates and potential intervention limit CHF’s attractiveness. All told, we think that the ongoing EZ debt crisis coupled with the potential for a recession keeps the euro range bound for now and thus makes sterling more attractive which is corroborated by recent positioning trends.

EM continues trade directionless for now with few currencies really benefiting from the recent rebound in risk appetite. Besides heightened uncertainty over further FED action, US data and EU periphery issues, EM investors are being forced to review expectations for monetary policy across the board. Mexico’s dovish statement and the risk of a cut by the Brazilian central bank tomorrow are good examples. Since market sentiment started to improve in the middle of last week, TRY and ZAR have been the best performing currencies. Turkey’s current account did come in a bit better than expected, but we think the move is mostly positioning driven given the magnitude of the recent selloff. ZAR’s gains were also likely positioning driven. Today’s lower-than-expected Q2 GDP for South Africa confirms out base case that economic growth remains lacklustre and unlikely elicit tightening by SARB in the foreseeable future, as many had previously expected. On the other end of the spectrum, MXN and INR have been amongst the worst performers. In both cases we expect further underperformance. MXN will be weighed the dovish central bank and downside risks to US imports. Despite a more hawkish RBI, India’s fundamentals are considerably weaker than most of its regional peers given the large twin deficits and susceptibility to short-term capital outflows.