Euro Recovers As Markets Await New Greek Budget Cuts

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The following is a post by Marc Chandler, global head of Brown Brother Harriman’s top ranked Currency Strategy Team. For more of BBH’s currency views, please visit the BBH FX website here.

Highlights

The US dollar was largely weaker vs. the majors, as early gains were wiped out during the North American session.  EUR/USD made a marginal new low of 1.3436 before bouncing sharply.  Sterling continues to underperform ahead of BOE meeting (see below).  While euro may have been helped by expectations that Greece will announce new budget cuts Weds, we think sentiment on Europe and the UK will remain negative, and market is likely to still favor selling euros and sterling into strength.  Yen was largely firmer and so dollar/yen moved back below 89.  Biggest gainers on the day vs. USD were CLP, HUF, COP, CZK, and BRL, while only losers vs. USD were NZD, PKR, IDR, GBP, and KZT.  EM currencies were mostly firmer.  CAD outperformed again, helped by more hawkish BOC comments after it left rates unchanged (see below).  Singapore PMI rose to 51.9 in Feb from 51.4 in Jan.  BRL gained to its strongest level vs. USD since Jan 21, helped by news of planned BRL 10 bln IPO.

US equity markets were mostly higher, with DJIA, S&P, and NASDAQ flat, up 0.2%, and up 0.3%, respectively.  European markets were higher, as DJ Euro Stoxx 50 ended up 0.9%.  Asian equities are likely to open up today as Asian ADRs were higher during N. American trading Tues.  Nikkei futures point to a flat open for Japan but the stronger yen should hurt Japan exporters.

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US bond market was mixed, as 2- and 10-year yields were down 1 bp and flat, respectively.  European bonds were mixed, with 10-year yields in UK, France, and Germany down 6 bp, up 1 bp, and up 1 bp, respectively.  In the periphery, Greek 10-year yields fell 10 bp, Portugal fell 3 bp, Italy fell 1 bp, and Spain rose 3 bp.  UST issuance is light this week after last week’s heavy auction schedule.

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The rating agency Fitch has warned that the UK is the most vulnerable of the AAA rated countries to the financial crisis and should trim its budget deficit more sharply in the next four years.  While the news is weighing on the pound and could signal that Fitch may shift its outlook (currently stable according to Bloomberg), it would not be the first rating agency to do so.  S&P, which also rates the UK at AAA along with Moody’s (Moody’s Aaa is equivalent to AAA) has already put the UK on negative watch in May 2009.  Our own ratings model puts the UK at AA and some asset managers may be in agreement with us given data from the BoE showing foreign investors reduced gilt holdings in Jan.

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The Bank of England is starting a two-day MPC meeting today, with a policy announcement due on Thursday.  We expect no change in interest rates, but while other G10 central banks have or are about to enter exit strategies, the Bank of England may still be discussing the merits of delivering further QE. Indeed, the BoE has completed its £200bn asset purchase program last month, but the message from the UK monetary authorities has been clear: all options are still open at this stage, including introducing further QE. We expect no change on rates or on the QE front on Thursday, but the risk for fresh QE has to be acknowledged.  If anything, the domestic economic case for further QE measure/announcement has strengthened a little since the last meeting, while the jump in January inflation was mainly the result of one-off adjustments and should not weaken the doves’ case too much. However, in the current context of significant political uncertainty, the best approach on the monetary policy front is probably to wait and see for another month and until a new government is formed and the air is cleared regarding medium-term fiscal policy prospects. It should be all about ‘wait and see’ at the BoE on Thursday, but expect the MPC to keep all options open at this stage, implying that the uncertain monetary policy outlook environment that has dominated in the UK over the past few months will stay in place.  In turn, this is also consistent with our view that the BoE will probably be amongst the last G10 CBs to contemplate its exit strategy. Combined with a highly uncertain near term political environment, all this will leave the British pound vulnerable. Bearing in mind, the sell-off of the past few sessions, investors may become increasingly nervous to sell the pound at those levels though. Look for a rebound towards $1.51 as a good opportunity to add on to short positions.

The Bank of Canada took a more hawkish stance boosting the Canadian dollar. While the target overnight rate was left unchanged at 0.25% as expected, the central bank indicated that inflation risks were no longer tilted to the downside and that core inflation has been slightly firmer than projected.  The BoC acknowledged that Canadian economic activity has been higher than it had projected in the Jan MPR.  That said, the BoC reiterated the target overnight rate would remain at current levels until the end of Q210.  The consensus of forecasters is for the BoC to hike 50 bp in Q310 although about 30% of forecasters surveyed by Bloomberg expect a hike in June. The bottom line is that the BoC is likely to hike ahead of most other major central banks including the Fed.  The US dollar is testing the C$1.0320 area we noted in the morning commentary.  A break could open a move toward this year’s lows around C$1.0200/10.

Greek bonds are continuing to recover from the sell-off at the end of last week that took the 10-year yield to 6.65%.  Now quoted near 6.15%, it is the lowest yield since Feb 11, down 10 bp Tues.  The key consideration is that Greece has 1) delayed the bond offering expected this week after being postponed last week and 2) indications that Greece will announce new savings measures.  These new savings measures are thought to be part of the precondition for material assistance that some suspect will emerge from Papandreou’s meeting with Merkel on March 5.  Reports last week suggested the Greek government was working on a package of additional measures that would be worth around 3.5 bln euros.  However, the form, amount and conditions of the assistance are far from clear.  In fact, an EU spokesperson indicated that this week’s EU-Greek talks did not include a potential bailout.  We had thought it reasonable that whatever mechanism that Europe agrees upon for Greece would provide not simply a precedent but a framework for other euro zone members.  However, the ad-hoc approach floated of using German and French government investment arms, seems particularly difficult scale.  As daunting as the Greece situation may be, the scale of Spain’s challenge is even more so.  News that Spain’s unemployment, already the highest in the euro zone, rose further in February underscores its dire straits.  The number of Spaniards registering for unemployment rose by a little more 82k or 2% to 4.1 mln.  Jobless claims are up 19% year-over-year.  Around half the jobs lost in the euro zone in the past two years took place in Spain.  Spain’s working scheme creating an estimated 400k jobs expired at the end of last year.  As Spain unwinds some of is fiscal support, ostensibly in order to avoid Greece’s fate, a similar job creating scheme this year is half the size.  According to BIS data, as of the end of Q3 2009, German and French banks had a combined $111.6 bln exposure to Greece.  Their exposure to Spain was estimated at $429.1 bln.  Total Greek debt was estimated at $235.3 bln.  Total Spanish debt is estimated at $857.5 bln.

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This material has been prepared by Brown Brothers Harriman & Co. (“BBH”) and is intended for information purposes only.  This communication should not be relied upon as financial, investment, tax or legal advice.  This communication should not be construed as a recommendation to invest or not to invest in any country or to undertake any specific position or transaction in any currency.  This information may not be suitable for all investors depending on their financial sophistication and investment objectives.  The services of an appropriate professional should be sought in connection with such matters.  The information contained herein has been obtained from sources believed to be reliable, but is not necessarily complete in its accuracy and cannot be guaranteed. Sources used are available upon request. Any opinions expressed are subject to change without notice. Please contact your BBH representative for additional information. BBH’s partners and employees may own currencies in the subject of this communication and/or may make purchases or sales while this communication is in circulation.

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