Sentiment Deteriorates Amid Concerns over Growth

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  • Dollar, yen and Swiss franc broadly higher; sentiment deteriorates after Bernanke’s speech
  • Euro trips ahead of $1.47 amid concerns over Greece’s package and soft German IP
  • Brazil and Poland both expected to hike by 25bps; Brazil’s president replaces Chief of Staff

The nascent stabilization in equity markets proved to be a pause before another leg down as Fed Chairman Bernanke voiced caution on the recovery and the labor market but gave no sign of QE3. As such, movement across the G10 was dominated in part by supportive interest for the US dollar, yen and of course the Swiss franc, while the commodity bloc suffered amid its sensitivity to the prospects of the near-term growth outlook. Despite the euro’s recent resiliency to the problems in the periphery, the marked runup in periphery yields and CDS pricing is taking its toll with the euro losing steam again ahead of $1.47 as officials are still unable to secure an agreement on Greece’s aid package. As a result, bunds and gilts are higher with the flight to quality prompting continued selloff in the equity markets, with the sharp drop in yields relative to Treasuries the likely catalyst for the dollar strength. Asian equities were mostly lower as investors continued to show angst over the global recovery, while European stocks dropped for a sixth straight day. Elsewhere, oil headed back to $98bbl amid growth concerns and expectations of an OPEC rise in output.

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As the market becomes more resilient to the Greece news flow, relative monetary policy and the global risk backdrop are likely to dominate direction near term, leading to a tug of war between drivers. For one thing, the euro continues to firm despite the strains apparent in the euro zone periphery, with the Portuguese 10-year marking record highs and European financials marking a new bottom. Equally important, DJ Newswires reported on a letter from German Finance Minister Schaeuble in which he is calling for a new aid program for Greece involving holders of Greek bonds via a bond swap that will lead to an extension of outstanding Greek sovereign bonds by seven years. The tone of the Greek discussions remains alarming in the midst of a Great Bargaining between official donors and the private sector, with the risk of a disorderly default looming large without another disbursement of funds for Greece before mid-July, although we are inclined to see the scare tactics as a method of extracting “voluntary” support from private bondholders rather than as a factor increasing the probability of near-term Greek default, particularly while the Greek parliament is voting on the new austerity measures. At the same time, euro zone GDP growth was confirmed at 0.8% – a clear acceleration from the 1.9% y/y rise in Q4 last year. Indeed, a strong first quarter which was primarily driven by strong German growth but elsewhere growth is also stabilizing, with even the likes Greece reporting a rise of 0.8% q/q. Spain, France, Italy all reported positive growth rates and data will add to the arguments of the hawks at the ECB for further rate normalization. Indeed, the ECB tightening bias is likely to support the euro on the crosses but technical levels are also key for the euro’s momentum to continue. In our view, a failure to make a convincing break of $1.47 ahead of the meeting is a signal of near term retracement with the euro likely to retest $1.457.

In Brazil, we expect Brazil’s central bank to deliver a well telegraphed 25bps hike, which is likely to see the SELIC target rate increase to 12.25% from 12.0%. In our view, a weakening external outlook and signs that inflation is moderating will not be enough to sway the COPOM. We will, however, be attentive to a dovish change in the statement, most likely the language, which is important for directional cues. Equally important, overnight OIS rates imply no further rate hikes and in fact the most likely outcome from the OIS market suggests that the target rate is likely to remain between 12% and 12.25% over the next few months. As a result, we do not have a strong view about USD/BRL at these levels and prefer to say on the sidelines but a dovish statement coupled with a further retrenchment is risk appetite is likely to lead to dollar strength with a convincing upside break of 1.589 likely to lead to test of 1.60. In addition, the main news overnight from the EM space was the replacement of Brazilian President Dilma’s powerful Chief of Staff Antonio Palocci who was recently implicated in a corruption scandal. Senator Gleisi Hoffman, also from the PT party, will replace him. The change is likely to garner little market reaction in the short term. In the medium term, however, a corruption scandal so close to the heart of the new government may have important implications political implications of Dilma’s government. Further down the line this could have implications for the PT’s ability to keep a tap on fiscal spending, pass reforms and face challenging wage negotiations next year.

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