Is the Fear Becoming Self-Fulfilling?

BBH CurrencyView

• The dollar continues to remain firm against most of the majors; global stocks down sharp
• Risk appetite took another turn for the worse; dollar bloc and scandis remain most sensitive
• Outside the carnage in EM equities, funding strains are emerging in some EM countries

The dollar continues to remain firm against most of the majors as Asian and European stocks experienced another round of deep losses following the 4.4% loss in the S&P on Wall Street. Despite the sharp moves in equities, the FX markets remain relatively calm with the NOK the biggest mover against the dollar, down 0.4%. The euro is barely off yesterday’s North American close, down 0.2%, driven in part by the relative calm of the periphery debt markets, which are likely being supported by ECB bond purchases. In fact, the on-the-run 10-year yields on both Spanish and Italian debt continue to remain below 5%, even though Greece’s 10-year is up nearly 21bps. At the same time, both the CHF and JPY have been restrained by intervention risk, leaving both real money and sovereigns to seek safe haven alternatives. In the equity space, Asian stocks declined over 3% (according to the MSCI Asia Pacific index), while EuroStoxx 600 has dropped another 2.5% ahead of the NY open, with bank stocks down roughly 3%.

The markets continued to be rattled by yesterday’s price action, with risk appetite taking another turn for the worse driven by weak US data and EZ banking concerns. We expect that the US economy is likely to avoid recession in H2 of 2011 but one likely scenario is that the recent price action in the markets reflects inventors’ fears about the state of the global economy and news cycle. Fear, in turn, can be self fulfilling as feedback loops from negative sentiment can alter the availability of credit or it can cause consumers to become more cautious with spending behavior. As a result, not only has a bank borrowed dollars from the ECB this week for the first time since Feb, but Fed data released after the US markets closed showed that the SNB also activated its swap line with the Fed, drawing $200 mln. Indeed, US financials conditions have deteriorated to 1.3 standard deviations (SD) from normal (though this index have yet to test its recent low near 1.6SD) while cross currency basis swaps suggest that investors must now pay an 82bps premium to swap euros for dollars (although the aftermath of Lehman caused this premium to rise by 205bps). In short, though, the immediate concern at hand is that market sentiment deteriorates at a rate that it actually starts to impact the real economy. On the other hand, it also is worth noting that despite the downside surprises in the recent survey and confidence data, informally know as “soft” data reports, “hard” data surprises (industrial production, vehicle/ retail sales) and high frequency initial jobless claims are not indicative of a sharp weakening in the economy. Nevertheless, without a clear impetus to revive sentiment in the near-term it is possible that the S&P retests its lows near1101, which is likely to lead to a marked selloff in the risk-sensitive currencies. This scenario would likely lead to another leg down for the dollar bloc, and scandis (a drop of at least 2% likely), with the euro expected to test the lower end of its recent $1.40 -1.45 range, while the CHF and JPY extend their recent gains.

In the EM space, beyond the obvious carnage in the equity markets signs of funding strains are emerging in several markets, which are similar to what we are seeing in the sovereign peripheral debt market. Cross currency basis swaps indicate the extra premium investors are willing to pay to borrow in foreign currency. Some of the sharpest moves occurred in Korea, Hungary, Poland and Honk Kong, where foreign borrowing private sector by is very common. In Korea, 1-year KRW/USD CCBS widened 60bp to 230, a level not seen since late 2009, but nowhere near the extreme high of 600 in October 2008. In Hungary, the HUF/EUR CCBS is down 93bp to 240, rapidly approaching its record high level of 275 on February 2009 as concerns about FX linked debt weigh on sentiment. The PLN/EUR CCBS widened 94bp this month to 160 for the same reasons, but still some way from the record level of 255 on March 2009. CCBS rose 28bp in Hong Kong, a modest absolute move in comparison, but unlike the other cases, we are now at a record high level of 48, far beyond the March 2008 high of 30. For comparison, EUR/USD CCBS are up 15bp to 46, compared with the record level 129 in October 2008. So what does this mean? One likely interpretation is that many institutions have large currency mismatches between their assets and liabilities and are now getting squeezed. In other words, they are unable or having to pay up to rollover funding for their investments.

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