Spain has replaced Greece and Portugal as the chief source of market anxiety
BBH Currency View
Rising tensions in Europe continues to be a dominant force in the foreign exchange market, with the euro briefly dipping below the $1.30 level for the first time since mid-February. Another reflection of the tensions is the further recovery of the Japanese yen. The dollar slipped below JPY80.50 in Asia, a level not seen since late-February, despite expectations that it will report another trade deficit (for March on Wednesday) and that the BOJ may succumb to pressure to expand its asset purchases at the April 26-27 meeting. The RBA releases the minutes from its March meeting tomorrow. It is expected to show scope for lower rates and after a large local bank raised its variable mortgage rate before the weekend, there would seem to be greater pressure on the RBA to cut rates when it meets in May.
The MSCI Asia-Pacific Index fell about 0.9%, but the gap lower opening after Friday’s gap higher opening leaves a bearish island gap in its wake. Asian equity markets open late, like India and the Philippines, benefitted from the more stable tone in Europe, where the Dow Jones Stoxx 600 is up about 0.5% near midday in London. Oil and gas, basic materials, and utilities are rising to offset weakness in technology and continued weakness in financials. Peripheral European bonds remains under pressure, and of note, French bonds are trading heavier, while German 10-year yields fell to new record lows. Spain’s 10-year yield is breaking above 6% and the 5-year CDS is at new record highs. This is ahead tomorrow’s bill auction and, more importantly, the bond auction on Thursday (when France, too, will be selling bonds, ahead of the first round of the presidential election on Sunday). Investors will also watch tomorrow Germany 2-year auction after last week’s auction was not fully covered.
Spain has replaced Greece and Portugal as the chief source of market anxiety. It is not clear what investors are more concerned about; that it reaches its deficit targets or that it doesn’t. Perhaps the worst combination is that it tries and fails. Trying means more austerity and this despite the contracting economy, falling house prices and rising unemployment. The IBEX is bucking the firmer tone of European bourse by losing about 0.3% and bring the loss today to 15.6%, giving it the dubious honor of the worst performing equity market this year.
The ECB has been most notable in its absence. It does appear that resuming ECB’s sovereign bonds purchases (SMP) is more likely than a new LTRO. However, a consensus may prove elusive as ECB’s Knot hinted at before the weekend, indicating that reactivating the SMP was not at hand. The flare up of tensions will make it more difficult for the Europeans to convince the G20 members that they should pony up more funds for the IMF to help Europe. Italy would like investors to believe that it is being hit by the knock-on effect from Spain. While there is some truth to the charge, there are also developments in Italy which undermines investor confidence. Italy’s 2012 budget projections were partly built on optimistic growth assumptions. It will cut them in the middle of the week. More importantly, there is concern that Monti’s honeymoon has ended and the support for the technocrat government is waning. France is moving into the spotlight too. While investors are understandably nervous about the Socialist challenge, Sarkozy’s campaign rhetoric warns that even if he somehow manages to defy odds and win the second round, the Merkozy fantasy has broken down. Barring an extremely cynical read, Sarkozy’s agenda puts him more at odds with Germany.
The central banks of Canada and Sweden meet this week. The Bank of Canada meets tomorrow and is widely expected to remain on hold. Its monetary policy report on Wednesday is seen to be more important. Later in the week, Canada reports March CPI figures and a substantial decline in the year-over-year rate is expected. Sweden’s Riskbank meets Wednesday. Soft industrial production data and the government’s reduction in its growth and inflation forecasts may increase the risk of an unexpected rate cut, but on balance, we look for it to stand pat.
China’s move to widen the dollar-yuan band to 1.0% from 0.5% is the subject of much talk today. Note that China maintains a band of 3% against most of the other currencies that it permits to be traded. The wider band does not signal quicker appreciation of the yuan. In fact, today it fell 0.2% against the dollar. Instead, it may be precisely because it is not going to let the currency move very much this year that it has widened the band. It is only a move toward convertibility in the sense that the move in 2007 from a 0.3% band to 0.5% was also a step toward convertibility. Elsewhere in emerging markets, we look for Brazil to cut its Selic rate by 75 bp and India to cut rates 25 bp this week. Other emerging market central banks that meet this week include the Philippines, Chile and Turkey; all of which we expect to stay on hold.
Of course Spain is a concern. It will show that the banks need to be reined in substainially. Until the crisis Spain had better national figures than Germany or France. Now because of its housing bubble its regions are bust and its banks are trading illegally as they are insolvent. They might have plenty of money courtesy of QE and LTRO but the overall liabilities of the banks mean that they are on the verge of collapse. This means that if Spain struggles then you can forget further bailouts to Ireland and the other PIIGS as Spain will drain the reserves.
So banks need to be aware that Ireland will default and that will not be pleasant. The population might round on politicians for the five years of pain only to go into default anyway. Longer term this could mean the end of the Washington Consensus and current policy as it is an evolutionary dead end.