Euro Vulnerable As Periphery Wobbles And Middle East Simmers

from the Brown Brothers Harriman Currency Strategy Team

Highlights

The dollar is largely confined to narrow trading ranges, with sterling one of the day’s top performers following BoE’s Sentance comments that the inflation report understated the real inflation risks. Cable moved back above $1.610 but met resistance around the $1.614 area. The euro was little changed but downside risks abound as the dollar is likely to be supported by higher yields, helped by stronger economic data today. The news of a surge in overnight borrowing from the ECB has not impacted the euro much, but could add to the negative euro sentiment. EUR/GBP is near session lows. At the same time, the dollar is slightly weaker against the yen and the Swiss franc as tension in the Middle East and North Africa is helping boost safe haven assets. EM currencies are holding up well, however.

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Global equity markets are mixed as well-received earnings reports help support stocks, but concerns over the political unrest in the Middle East has tempered sentiment. Asian stocks probed higher again, leaving the MSCI Asia Pacific index near one-week highs, up 0.6%, in tandem with the S&P’s move up to 32 month highs. Japanese stocks rose, sending benchmark indices to their highest levels in almost nine months. European bourses are little changed near two-and-a-half year highs, with the Euro Stoxx 600 up 0.1%.

Global bond markets are mostly higher. In Europe, Spanish yields are higher for the first time in three days after weak demand seen at today’s auction. Overall, the total amount sold was less than the €4bln planned, while the bid-to-cover in the 10-year auction was down from 1.67 at the last auction. The tepid auction led to a modest rise in periphery yields, while German 10-year bund yields were lower, down 1 bp. Of note, there was a report in Portugal’s Jornal de Negocios that Germany has been pressuring Portugal to request an international bailout immediately, before any changes to the European rescue package are decided at a summit in March. Swedish CPI data validated the Riksbank’s tightening bias.

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Currency Markets

The dollar is trading in very narrow ranges, but looks set to gain further against the euro. We were perplexed by the euro’s rebound yesterday, ostensibly on the back of news regarding a rise in Iran-Israel tensions. That sort of news is typically dollar-positive, and so we would look for the euro’s gains to continue fading today. Peripheral spreads are modestly wider on the day, with Portugal 10-year yield above 7% for the 10th straight day and so that should help the dollar recoup some of its losses. Note that the 2-year US-German spread continues to fall in the dollar’s favor, today hitting 54 bp, the lowest since January 13. News that demand for overnight loans from the ECB jumped to the highest in 20 months yesterday can also be seen as euro-negative, indicating that stresses remain in the banking sector.

Bank of England policy maker Andrew Sentance said it should raise interest rates to boost the pound, which would help to contain price pressures. Sentance has long been the most hawkish on the MPC and so his comments should not be surprising to the markets. Sentance expressed skepticism that CPI will fall back to its target by mid-2012, and warned that complacency about the weaker pound may have been justified during the depths of the crisis, but not when commodity prices are surging and the global economy has healed. Market expectations for BOE tightening have crept up steadily, with 1 year OIS moving from less than 10 bp in October to a high of 87.5 bp on Tuesday. Since the BOE report, however, that has fallen back almost 10 bp to around 79 bp currently. Meanwhile, Sweden inflation exceeded the Riksbank’s 2% target for a second straight month. Headline inflation accelerated to 2.5% in January from 2.3% in December, though it came in lower than the Bloomberg consensus for 2.6%. Earlier this month, the Riksbank projected four more 25 bp hikes this year that would bring the policy rate up to 2.5%. While today’s inflation data is unlikely to change that trajectory, SEK is the worst performing currency of the majors today.

China State Administration of Foreign Exchange (SAFE) estimated that $35.5 bln of “hot money” flowed into mainland China in 2010. Though this amount is a bit more than the average annual inflow seen over the past decade, it still only accounted for less than 8% of last year’s gain in foreign reserves. The average annual net inflow of hot money was about $25 bln over the last 10 years, SAFE estimates. This report suggests that the PBOC may not so worried about the effects of hot money inflows stemming from its rate hikes, and supports our views that it will continue to follow a combination of rate hikes, reserve requirement hikes, and currency strength to limit price pressures this year. We continue to downplay the risks of a hard landing, and look for close to 5% yuan appreciation over the next 12 months.

There is ongoing political uncertainty in the Middle East region but EM currencies remain bid, helped by positive investor sentiment as US stocks continue to climb. Developments in Tunisia and Egypt continue to reverberate in the region, with anti-government protests continuing in other countries. This is one of the factors behind the relentless climb in Brent crude prices, now back over $100 per barrel for the 7th straight day and making new highs. However, there has been some good news out of Brazil, President Rousseff and her PT-led coalition in Congress was able to approve a minimum wage of BRL545. Despite fears that a higher wage would be pushed through, this outcome should help the government’s plan to cut BRL50 bln from the budget. Lawmakers rejected two amendments pushed by the opposition with the support of unions to raise the minimum wage as high as BRL600. The bill now goes to the Senate. Brazil policy-makers must continue to show fiscal restraint in order to calm market concerns about inflation, and the minimum wage vote is a good start.

Upcoming Economic Releases

At 8:30 EST / 13:30 GMT the US data reports begin with January CPI (0.3% m/m expected vs. 0.5% prior), while core is expected to remain unchanged at 0.1%. February 12th initial jobless claims are expected to increase to 400k from 383k prior, while January’s leading indicators are expected to slow to 0.3% from 1.0%. Afterwards, February Philly Fed is expected to increase to 21.0 from 19.3. Canada’s December whole sales are expected to moderate to 0.9% from 1.2% Events: Bernanke testimony at 10:00 EST / 15:00 GMT followed by Raskin, Fed speakers include Lockhart (non-voter), Evans (voter), Fisher (voter) and Hoenig (non-voter) starting at 12:00 EST / 17:00 GMT, BoC Review Published at 10:30 EST / 15:30.

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