Cautious Rebound amid ECB’s Containment Strategy

BBH CurrencyView

  • European stocks, Italian bonds and the euro are rebounding after Italy’s BTP auction and ECB containment strategy
  • European political uncertainty remains dominant driver; Australia employment better than expected
  • Bank of Indonesia surprised markets with a 50bps cut; China’s trade balance shrunk on strong imports
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European stocks, Italian bonds and market sentiment in general are rebounding into the black after signs that Italy is speeding up the passage of its austerity bill, together with a decent Italian BTP auction and containment from the ECB. The Italian 10-year generic yield is currently at 6.92%. Sentiment is also improving amid fresh talk of an unscheduled ECB meeting today to authorize unlimited bond purchases. As a result, European bank shares are marginally higher, up 0.3%, though the long-term concerns remain as Germany’s CDU party is exploring ways for countries to exit the euro zone without leaving the EU. US S&P futures indicate a positive open, up over 1%. The BoE, as expected, left the repo rate at 0.5%.

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Political uncertainty in the euro zone continues to dominate price action. Indeed, as we have argued this continues to be a crisis of confidence that in turn is weighing on economic activity. Today’s weaker than expected Italian and French September industrial production data underscore this point. But amid the chaos it is important to keep in mind that Italy is not Greece. Italy’s existing debt carries a relatively low interest rate of 4% and the average maturity is seven years. That means the rise in market rates will take quite a while to filter through. What’s more, even if 10-year yields remain at 7% this is still well below the highs of the 1980s and 1990s. Italy, unlike Greece, is already running a primary budget surplus, so the austerity measures needed to make the Italian fiscal position more sustainable are much less severe than needed elsewhere. That means in the near term, Italy can cope with the uptick in market rates, but the developments highlight that sustainable budget policies have become are necessary to restore confidence. This is equally important for economic growth as well. From here, in the very short-term to restore it will be absolute necessary that Italy approves the recent fiscal measures and moves forward with either a coalition or technocratic government. Yet a much more committed intervention strategy from the ECB may also be required as the EFSF is unlikely to be up and running anytime soon. Altogether, more aggressive bond buying from the ECB could ease some pressures, causing both euro and risk appetite in general to consolidate.

Beyond Europe, Australia’s employment report was better than expected confirming a slight tightening of the labor market, despite the recent deterioration in other macro data. Employment rose 10.1k in October and the September’s number was revised up by 2.1K. Full time employment bounced 20.0k in October, continuing the 13.7k increase in September. Part time jobs reversed 9.9k after an 8.8k rise in September, while the unemployment rate dropped to 5.2% in October from 5.3% in September. What’s more, the participation rate was steady at 65.6% in October. The data on the whole confirmed a slight tightening of the labor market, despite the recent deterioration in other macro data. As a result, we continue to believe that the 150bps of cuts priced into the RBA policy is too aggressive and in turn is unlikely to materialize. Less easing than expected along with China’s more accommodative policy will eventually support, which may support the AUD in H1 2012. Nevertheless, we still expect the RBA to cut by another 25bps in the months ahead and therefore would be cautious of the AUD/USD in the near term, especially in the current volatile environment for risky assets and commodity prices. A relief rally is likely to meet resistance between 1.020-1.037.

The bank of Indonesia surprised markets by cutting 50bps in today’s meeting. Expectations were for a 25 bp cut or for no change. The move was attributed to lower inflation pressure, but curiously, the central bank also stated that it expects 2011 GDP to come in at a robust 6.5% yoy. Authorities had signaled that rate cuts were forthcoming but, in our view, today’s decision was far more aggressive than what the comments or the economic data suggests. IDR was one of the worst performing currencies on the day weakening to levels not seen since early October. Despite the surprise, we retain our relatively positive view towards IDR and think that today’s sell-off will prove to a buying opportunity, especially against other EM Asian currencies such as MYR, INR and KRW. China’s exports rose 15.9% in October compared with October of 2010. That follows a 17.1% y/y increase in September. Imports grew by 28.7% y/y in October following a 20.9% gain in September. The trade surplus improved to $17.0 bln in October from the $14.5 bln surplus in September. On the whole the strong import growth points to resilient domestic demand (which is likely overtime to be supportive of the Antipodeans and Asian currencies) and argues that the CNY should continue it upwards trend.

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