Default Risks Intensify

BBH CurrencyView

• EUR/USD breaches 1.35 (new trend low) and stocks hit 26-month low amid Greece default concerns
• This week is likely to be dominated again by European headlines and US economic data reports
• China data support soft landing scenario; Central banks in Russia, Chile and India all meet this week

Concerns about Greek default and global growth jitters are weighing heavily on bank stocks and cyclical commodities into the New York open, supporting a broad-based advance in the US dollar. French banks have come under significant pressure with the CAC 40 financials index down 10% this morning to a post-Lehman low amid concerns about Greek debt exposure and the possibility of a France downgrade. Commodity based sectors are also weighing heavily in London with materials down -3% and oil & gas -2.7% as the underlying markets ease. Copper fell to a one-month low, down $158, or 1.8%, $8663, having touched $8650 earlier, the lowest level since August 11. WTI Crude for Oct11 delivery fell $1, or 1.2%, to $86.2bbl, low having found near-term support at the $85bbl mark earlier. US Treasury 10yr yields fell to a new record low of 1.877% in Europe and Bund futures reached new lifetime highs of 138.57 in a sign of an overwhelming drive towards deleveraging and capital preservation which maintains a continued strong correlation between haven assets.

The week ahead is likely to be marked by a continued focus on European headlines and US economic data, with the EUR/USD likely to remain under pressure and the dollar expected to remain bid amid signs of waning market confidence. The EUR/USD, in particular, is expected under pressure across as the combination of a potential Greek default, a shift in ECB posture, divisions between policy makers over how best resolve the ongoing debt crisis and funding worries about European banks continue to rattle markets. As a result, the 3-month basis point premium paid to swap euro’s for dollars reached a 2.5-year high of 115bps today, while European bank shares wobbled by nearly 4%. Still, at the height of the Lehman Brothers crisis the euro-dollar basis swap premium was over 210bps. But nonetheless, with the CDS market pricing in an imminent default of Greece amid talks that the German government may be discussing an orderly restructure and press reports over the weekend suggesting that some large European financial institutions are facing the prospect of a credit downgrade due to their exposure to Greece, we suspect that the euro and broader market sentiment are likely to deteriorate further yet. Additionally, we suspect that the estimated €16bln issuances in periphery debt are likely to lead to increased funding costs which in turn should add to the headwinds for the euro. Against this backdrop, a downside break of the February low near $1.343 is likely to open the door for the EUR/USD to 1.336% and roughly a full retracement of the year’s entire move. In the US this week, we get the first round of September data (Empire and Philly surveys), along with August’s retail sales figures. The latter will provide the first glimpse of the household response to the plunge in equity prices at the beginning of the month, while soft survey readings could be further signs of softer growth momentum, prompting further demand for USD.

In the EM space this week markets are likely to focus on Chinese loan growth data, which will be important for signs of a potential slowdown in credit growth, along with central bank meetings in Russia, Chile and India. We do expect inflation to fall further in the fourth quarter yet overall the decent set of Chinese data (which revealed record imports and a rebound in lending) continues to support the notion of a soft landing. Indeed the strong import data led to a narrowing of the trade surplus while the slowing in money growth is likely to suggest that inflation is likely to have peak. In the medium term that is likely to remain supportive of Asian growth and in turn likely to support G10 currencies like the AUD and NZD due to their demographic links to China. In our view, India is the only central bank expected to hike but given the rapid deterioration in market condition, we acknowledge that there are risks that it remains on hold. The key for the potential rate move is likely to Wednesday’s inflation print, which is expected to rise to 9.6% y/y in August from 9.2% in July. As a result of persistently high inflation the RBI is expected to combat the increase of price levels with a 25bps hike at this Friday’s meeting. And while we expect this potential hike to be one of the last for the RBI as the recent rate hike cycle draws to a close we suspect that the outlook for the USD/INR is likely to hinge on the outlook in broader market sentiment. In LATAM, we expect policymakers in Chile to keep interest rates at 5.25% when they meet on Thursday night. Weaker external demand conditions will be weighed against elevated copper prices and a pick-up in headline inflation in August to 3.2% y/y, from 2.9% y/y in July.