The Euro Clears One Political Hurdle

BBH CurrencyView

• Risk appetite improves in Asia and Europe; stocker higher, dollar softer amid hopes for US stimulus
• Germany’s Constitutional Court rules in EFSF’s favor; Beige Book, BoC highlight of today’s session
• Brazil’s data continues to call into question last week rate cut decision; Poland’s CB to remain on hold

European equities have rebounded this morning, with the Euro Stoxx 50 interrupting a four-session slide that saw it lose 8% of its value since the start of the month. Germany’s constitutional court removed legal challenges to the German parliament’s ratification of the Greek aid deal and the EFSF this month. This helped ease fears about an Armageddon scenario of forced sovereign default, providing support for valuation pickers; European financials rose 2.4% today. The market also took encouragement from stronger than expected Australian Q2 GDP data overnight and an unchanged Riksbank decision and is looking to President Obama’s speech on jobs tomorrow to add economic clarity on the outlook. The rebound in equities is driving flows out of haven strategies with US 10yr yields rebounding above the 2% mark (+4bps), German 10yr yields rising 6bps to 1.90% and Italian and Spanish yields falling 10 and 8bps respectively. Oil and copper prices advance, with oil up 0.8%.

Markets continued to be dominated by the EZ sovereign debt crisis and the uncertainty surrounding key political events this month, which are likely to shape the market response in the months ahead. Of the key political events that take place in the EZ this month, today’s ruling by the German Constitutional Court on Greece/EFSF was a big one. In effect, the German Court ruled this morning on a constitutional complaint filed by a group centered on MP Gauweiler with regard to the country’s participation in bailout of other EZ members. Parties in Germany’s ruling coalition, for example, sought to obtain greater Parliamentary involvement in decisions involving the EFSF. The Court ruled in favor of the EFSF, rejecting the law suits against rescue packages. This is not too much of a surprise, but nevertheless the decision brings more clarity to the situation at hand and has provided a modicum of support for the euro as it teeters ahead of key support levels near $1.40. At the same time, the euro is also getting a lift from the better than expected July German industrial production. In sum, the sharp rise in orders figures over the preceding three months points to a catch up effect in production, and the June number is partly a rebound from the 1.0% m/m decline in June. It supports expectations for a stronger Q3 GDP number, but yesterday’s contraction in manufacturing orders and the deterioration in confidence data suggest that a renewed slowdown in growth is likely in coming months. On the margins the recent economic slowdown is unlikely enough to expect a rate cut from the ECB this week yet the ECB will need to maintain (at the very least) a neutral tone to keep the euro above $1.40. Elsewhere, the Riksbank, as expected, left interest rates unchanged at 2% today, but while it softened its stance for now we still expect it to remain hawkish moving forward. As such, we expect SEK to underperform when market sentiment deteriorates due to SEK’s high beta and trade-based economy yet we doubt the Riksbank is likely to shift its policy stance anytime soon.

In the EM space, Brazil data continues to call into question the decision last week to cut rates. While it might be tempting to say it was justified as a preemptive move due to the deteriorating external outlook, domestic considerations say otherwise. IPCA inflation edged higher in August to 7.23% y/y, which was the highest jump in inflation since June 2005. The main reason for the increase in IPCA inflation was the seasonal rebound in food prices, which rose to 0.72% in August from -0.34% in July. The other reason is that service price inflation remained high. In particular,, meat prices rose to 0.84% from -1.12%. Non-food prices slowed to 0.26% (mom) in August from 0.31% in July. At the same time inflation expectations are still rising, and capacity utilization remained near the highs in July. Add in a big increase in the minimum wage and still-strong domestic activity, and we say the rate cut wasn’t justified. This feeds into perception that the rate cut (and most other macro policies) are being done because of the FX obsession. On the other hand, according to the implied probability from OIS swaps the market is still bracing for yet another rate cut on 10/19, with the OIS implying a greater than 50% of another 25bps cut next month. In our view, BRL is likely to remain under pressure amid the ongoing uncertainty in the EZ and while the global macro data continues to underperform. All told, this is likely to continue for the time being. We and the market continue to expect the Central Bank of Poland’s monetary policy committee to keep the policy rate on hold at 4.5%. Recent comments from several MPC members, including Governor Belka, have suggested that the MPC has shifted to wait-and-see mode to see how EZ policymakers address ongoing uncertainty.