Downgrades, Upgrades and US Inflation

BBH CurrencyView

• The dollar is broadly weaker as news developments remain mostly positive, boosting sentiment
• North American session sees US November inflation; euro likely supported today on short-covering rally
• RBI left rates on hold at 8.5%, as expected; IDR rallies after Fitch upgraded it to investment grade

The dollar is broadly weaker as the market remains more upbeat after yesterday’s positive news developments carried overnight through the Asian session. Overnight activity mostly consisted of rating downgrades with Fitch downgrading 10 Spanish banks and S&P downgrading 7 global banks. Nevertheless, the euro and sterling are both marginally higher but gains are limited amid concerns that some euro zone members may have their rating downgraded after the European close. AUD built on overnight gains and moved back over parity on a combination of higher stocks, short covering and year-end related hedging from corporate names. Stocks are narrowly mixed, with the EuroStoxx up 0.3%, while Asian shares were mostly higher, with the MSCI Asia Pacific index up 0.7%. Euro zone spreads have continued to consolidate, narrowing sharply following yesterday’s strong Spanish auction. European banks are higher for the second straight day and US S&P futures point to a positive open.

In the North American session today the data calendar is light but November CPI is likely to command a bit of attention. Market consensus expects that both the core and headline year-over-year are likely remain unchanged from October. Inflation is likely to be driven again by the change in vehicle prices, with further declines in gasoline and motor vehicle prices likely to be supportive of a muted inflation print. New vehicle prices increase substantially in the first half of the year, mainly as a result of the disruption of the supply chains due to the Japanese tsunami. This led dealers to reduce final incentives. However, with inventories back to normal, auto dealers have reintroduced incentives to boost sales of new and used cars, leading to a reduction in the final cost. This trend is likely to continue in November, with auto prices expected to reverse some of H1 sharp increases. Overall, the moderation in inflation has been key to restoring household purchasing power in both the developed markets and EMs. Indeed, one of the positive externalities of softening global growth is the drop in commodity prices tends to result in better household purchasing power. Looking ahead, if sustained, the moderation is inflation is likely to contribute to a firming of retail sales and economic activity.

Ahead of the weekend, the euro is likely sensitive to the continuation of the short covering rally that began yesterday after a handful of positive developments, though potential gains are likely to be capped amid talk of S&P rating downgrades for some euro zone members. From here, we see some additional scope for gains but expect euro sellers to re-emerge in the $1.305-70 area which translates in the 1.555-1.560 area for sterling. Otherwise, the main drivers have not changed and we still anticipate that the euro will close out the year at our target level of 1.29. European data releases this morning has been marginally supportive of sentiment, with French business confidence exceeding expectations (94 vs. 93), though still softer from the previous month. Looking ahead, the euro zone sees a host of central banks speakers, together with Italian PM Monti’s vote of confidence in the Italian parliament today. The vote of confidence is needed to increase the prospects of his austerity measures getting passed, which is essential to restore confidence in the Italian BTP market.

The RBI left rates unchanged at 8.5%, which was widely expected. It decided to pause in its tightening cycle, which has seen it lift rates 13 times since March 2010, but domestic fundamentals have started to weaken, along with the worrying developments in the global outlook. Today’s decision came after data showed earlier this week that November inflation was much lower than expected. The RBI chief said it cannot speculation on when it can cut rates, yet added that the INR fall was exerting upward pressure on inflation, which may have forced it to act against speculators today. He added that it would continue to use open market operations to manage liquidity. IDR rallied sharply through 9,000 after Fitch upgraded Indonesia’s rating to investment grade for the first time in 14-years to BBB-, citing the country’s strong and resilient economic growth and low and decline public debt ratio. After closing Thursday’s session at 9,080 it headed to 8,990 highs versus the dollar before settling around 9,030 ahead of the Asian close. The better risk backdrop helped the general tone in Asia, though IDR posted the biggest footprint in Asian FX by a wide margin, even though the Fitch move had been widely anticipated. What’s more, Moody’s and S&P tend of follow Fitch with a lag of roughly six months to a year. We nonetheless expect the INR to be driven by developments in the euro zone, suggesting that the currency is likely to remain under pressure for the time being.