Greece Continues to Dominate the Headlines

BBH CurrencyView

• European stocks rebounding amid talks of Greek government collapse, potential referendum withdrawal
• ECB likely to remain on hold but signal December rate cut; US service ISM key data report today
• EM focus on potential for China easing policy to boost economy; Australian retail sales firm

Overnight following no surprises from the Fed, market focus shifted back to headlines on euro zone with both Greece and Italy again in the spotlight. Market sentiment deteriorated in the Asian session amid concerns of a disorderly Greek default and lack of progress from Italy’s government on structural changes. Sentiment is reversing sharply, though, ahead of the New York open amid speculation the Greek government might collapse and reports that Greek may withdraw the referendum proposal. European bank shares are up over 1%, even though periphery yields are higher following bond auctions from both Spain and France. UK service PMIs shows waning momentum.

Greek headlines continue to dominate markets. Interestingly, markets rallied in the late London morning on speculation that Papandreous is losing further support in the government for the referendum which would cause him to lose the elections on Friday or even resign. A “no” vote of confidence would likely dash chances of a December referendum, even thought it would leave Greece temporarily without a government. This could lead to a short term extension of this morning’s rally market seems to think that no government and no referendum is a better scenario than Papandreos in the government and referendum. A meeting was called for later today with his ministers when markets expect to get more clarity. At this stage, the Greek referendum is expected to be held on December 4-5. Both French and German leaders stated that it should focus on whether or not Greece remains in the euro zone, rather than renegotiating the loan agreement. This scenario has a higher probability of succeeding since nearly 70% of Greeks recently polled said they wanted to stay in the euro zone. The Troika also applied further pressure on Greek authorities by withholding the sixth loan tranche until the referendum is held and political uncertainty removed. Nonetheless, the focus from here is how policy makers can mitigate contagion to the rest of the EZ, with Italy’s failure last night to make any progress last on economic reforms adding to the tensions. Onus indeed to fall on the ECB.

We do not expect the ECB to cut its policy rate in today’s meeting. Instead, we expect Draghi to focus on the ECB’s commitment to providing liquidity to the banking system and to signal a rate cut at the December meeting. In our view, a shift in the policy tone from neutral to dovish is expected to – counter intuitively – be supportive of the euro as it will signal that the ECB is finally responding to the worse growth prospects in the EU. In this scenario, we suspect gains are likely to be limited with resistance expected near the 200dma (1.4105). On the data front, US service PMIs is likely to show that the service industry continues to grow. Although the market expects the ISM non-manufacturing index to have nudged up in October, the weak economic backdrop is likely to prevent a significant rebound anytime soon. Nevertheless, after a marked slowdown since May, the growth rate of core retail sales, which can sometimes lead the ISM index, has recently edged higher. Of note, will be a focus on the employment component ahead of tomorrow’s payrolls reports.

In Asia many are focused on potential China policy easing in order to boost the economy. A little bit of market positive news out of China over the last couple of days. In line with our recent notes, local news sources confirmed suspicions that the government is moving towards selective easing after last week Premier Wen suggested the government would “fine tune” policy. The Shanghai and China Securities Journals confirmed that the authorities are lifting limits on commercial bank loans to the more credit strapped industries – though this would not include the real-estate sector. Consistently, local rates have fallen sharply, also driven by further liquidity injections by the PBoC. The 2-week shibor, for example, fell from 5.8% on Monday to 3.7% today. This is positive for EM in general and for Chinese assets in particular. Indeed, the Shanghai index has outperformed all other major and EM indices over the last few sessions and seems likely to continue doing so, in our view. Elsewhere, Australia retail sales rose 0.4% in September after the 0.6% gain in August and 0.8% bounce in July. Sales were 2.3% above the level in September of 2010, an improvement from the 2.0% y/y rate of increase in August, suggesting that while the housing sector remains soft domestic demand continues to remain resilient. As such, looking ahead we continue to think the RBA is likely to be less aggressive in easing policy as the market is currently pricing in but for now AUD remains driven by global events.