– NZD leads modest bounce vs USD, Asian equities mixed
– German Ifo likely to add pressure on the euro
– Our short term model estimates EURUSD at about 1.41
What to watch for today
EUR: Ifo likely to soften. Our economists forecast that the German Ifo moderated in May to 114.0 from 114.2 in April. Although directionally in line with the pullback in the flash PMIs for Europe out yesterday, our estimate is above the Bloomberg consensus forecast of 13.7. Our economists also expect a small upward revision to the second estimate for German Q1 GDP to 5.2%yoy from 4.9%yoy. Markets are likely to focus on the weaker Ifo numbers and their implications for the path of ECB rate hikes. The market currently remains fully priced for a 25bps hike in July and 83bps of hikes over the next twelve months.
NOK: GDP rebound. Our economist forecasts that Norwegian mainland GDP grew 0.8% qoq in Q1 after a disappointing 0.3% qoq rise in Q4, in line with the Bloomberg consensus. Solid domestic demand should be the main driver for the strong growth in Q1, while net trade should be flat. Such an outturn would be in line with the Norges Bank’s expectations.
EURUSD model update and scenario analysis
Below we use our EURUSD model to show a range of scenarios for the pair over the next few months. The model estimates that EURUSD should be at about 1.41 given current levels of interest rate spreads, peripheral sovereign credit risk, VIX and a proxy on euro speculative positioning. Exhibit 1 shows the out of sample fit of the model is good, while Exhibit 2 summarizes EURUSD sensitivity to the explanatory variables in the model.
Our latest EURUSD model update as of 20 May 2011 points to a value of 1.41, broadly in line with spot. Exhibit 3 shows scenarios for EURUSD for different levels of the EURUSD 2yr swap rate differential; and peripheral spreads, with all other variables held constant.
– A 50bp rewidening in German-US rate spreads, consistent with our Q3 forecasts, and a 50bp retightening in peripheral spreads, consistent with a return to early April levels, would line up with a EURUSD rate around 1.50. This is not far from our three-month forecast target of 1.52.
– To examine a risk scenario for our view, we can model a further 50bp widening in peripheral spreads to new crisis extremes and a further 25bp tightening in German-US front-end rate differentials back to early March levels. This scenario would be consistent with a test of the 1.3655 support level identified by our technical strategy team. We could also set up a challenge of this level if we were to take the German-US spread down 50bp to levels last seen in mid-February and widen peripheral spreads 25bp to the extreme levels seen in November of last year.
What happened overnight
Stabilization. Markets paused for breath in Asia with most G10 pairs essentially flat or a touch stronger against the dollar, with equities mixed. The Nikkei and Kospi rose slightly while Chinese markets were off 0.7% – 1.0%. FX implied vols eased slightly in line with the relative calm in the cash markets.
The NZD was the main exception, rallying against the AUD and the USD in reaction to a rise in inflation expectations. The Reserve Bank of New Zealand’s 2yr inflation expectations series rose to 3% in Q2 from 2.6% in Q1. This was the highest since Q3 2008. The Kiwi also benefited from New Zealand’s dairy cooperative announcing a further small increase in forecast payouts to dairy farmers to a new record of NZ$7.75 – 7.80 per share. We think the market is overplaying the importance of the inflation expectations data and expect the RBNZ to look through these numbers as affected by tax changes and the residual effects of the February earthquake.
Power shortages an increasing growth risk in China? The China Daily reported today that power shortages in China are increasing. This echoes recent warnings from our China economist, Dong Tao, that state fixing of electricity prices below generation costs given the recent rise in coal prices is leading producers to cut production to avoid losses. This poses at least some risk that industrial production data may disappoint markets over the next month or two. However, we doubt the government will allow this situation to be sustained for long. The China Daily noted that some electricity price increases seem likely soon. To be sure, the recent fall in vegetable prices in China may create some room in headline inflation for the government to allow higher energy prices.
Credit Suisse
FIXED INCOME RESEARCH & ANALYTICS