Peripheral sovereign woes weigh on the euro and buoy the US dollar
15/Nov/2010 • Currency Updates•
It was a difficult week for risk assets. Bad news kept hitting the tape relentlessly, including bad inflation numbers out of China followed by the announcement of further tightening of reserve requirements there; Cisco’s disappointing earnings report, which cast further doubts on the sustainability of the recovery in US capital spending; and, last but not least, the relentless sell off in peripheral sovereign bonds in Europe, as Irish and Portuguese surged to post-euro records (again).
Our generally bearish view of the euro and positive view of the US dollar was vindicated last week. Away from forex markets, risk assets suffered amidst the generalized risk reduction, as the SP500 closed down 2% and commodities fell sharply towards the end of the week, led by significant drops in precious metals (albeit from record highs achieved earlier in the week).
Peripheral sovereign problems appear to be a positive for sterling. GBP strengthened significantly against the euro while managing to hold its ground rather well against the US dollar. In addition, sterling was supported by the sharp repricing of QEII from the Bank of England. Money markets sold off sharply throughout the week, and the lessened prospects for monetary easing led traders to cover their short GBP positions. Sterling appreciated by over 2% against the euro and ended up nearly unchanged against the dollar.
We think that the markets are seriously underestimating the macroeconomic impact of the draconian cuts approved by the new Government. While recent GDP growth has been surprisingly strong, the cuts have yet to take effect, and the European peripheral examples are not encouraging. The somewhat disappointing industrial production report for September is, we believe, is a symptom of the weakness to come, and therefore remain bearish GBP against all major currencies except the euro.
European peripheral sovereigns were the driver of the common currency last week. They widened relentlessly on persistent talk that private creditors would be forced to take haircuts on future bailouts, until Friday, when European authorities clarified that any such “burden sharing” did not apply to the already approved EFSF, the euro-wide bailout facility.
We have been vocal about our fears on the unsustainability of the draconian austerity measures imposed on the peripheral countries in return for access to bailout funds. These fears are being amply justified by events and macroeconomic news. Unable to devalue their currencies, the relentless spending cuts and tax hikes are having a crushing effect on economic activity. After many months of cuts, the Irish and Portuguese deficits are higher than before austerity measures were implemented. The Spanish situation appears to be slightly better, but not by much. As talk intensifies that Ireland will be forced to tap the EFSF, the interest rate that it is charged will be critical to assess whether the bailout is sustainable over the medium term. We believe that the rates being discussed, on the order of 6-7%, are much too high and will only delay the default. While immediate access to liquidity is not an issue thanks to the EFSF, peripheral nations may be finding themselves in the curious situation of being liquid, but insolvent.
In any case, the brutal sell off in peripheral bonds, together with some mildly disappointing macroeconomic numbers (GDP growth, primarily) took a grim toll on the EUR, which ended the week down 2.5% against the dollar. Unless some sustainable plan is agreed upon to solve the peripheral issue, we see no reason to change our negative view of the common currency
The greenback was buoyed not only by the worsening peripheral troubles, but also by a steady drip of better than expected second tier reports on the US economy. Consumer confidence, weekly jobless claims and the September trade report all came out somewhat better than expected. This confirms the trend of the last few weeks, where the generally positive economic surprises contrast with lower than expected European numbers. This combined with still heavy short positions on the USD among traders to boost the dollar by a very healthy 1.6% in trade-weighted terms.
Another of our views that appears to be panning out is our bearish view on the Japanese yen. The possibility that the Federal Reserve will not purchase the full $600 billion that it announced on November 3rd weighed heavily on USD money markets, where yields rose steadily throughout the week. The still massively long JPY positioning among traders did not help the Japanese currency either. JPY ended the week down 1.7% against the US dollar, and is for now safely away from breaking its recent highs, which must be an enormous relief for Japanese authorities.
The sharp selloff in risk assets last week did not spare the commodity currencies, though there were sharp divergences among their performance. AUD and NZD sold off almost in tandem, down 2.5% for the week against the USD, while CAD held up much better, down just 1%. Our long-held view that the Australian dollar would outperform the Canadian dollar has proven correct, and with the cross rate between them at or above parity, we now turn neutral on this currency pair. However, we still think that the Australian dollar offers value against the other antipodean currency, the NZD, so long as the cross rate between those two stays below 1.30 – now around 1.27.
Inflation numbers out of Scandinavia came out almost exactly as expected. Without big domestic news to drive them, NOK and SEK both spent the week tracking risk assets, selling off about 1% against the euro while the cross between them remained essentially unchanged. The Swiss franc was a different story, as it benefited from the flight-to-safety bid and rallied a bit over 0.5% against the common currency.