– ECB and BoE meetings in focus
– We recommended going long SGD ahead of next week’s MAS meeting
What to watch for today
EUR: Risk of ECB disappointment. Our economists argue the ECB is unlikely to cut its policy rate today, particularly after surprisingly high inflation in September released last week.
However, they expect the ECB to extend the provision of the unlimited, fixed-rate funding timeframe into 2012, providing a further six-month LTRO, with an outside possibility that a one-year LTRO is also announced. Heading into the meeting, we estimate that the rate markets are pricing about 50% probability of either a 25bp cut in the repo rate target or a widening of the corridor, which would allow the EONIA rate to fall.
We think the EUR remains vulnerable heading into the meeting. If the ECB disappoints and leaves its policy rates unchanged, markets are likely to increase pricing of euro area sovereign default risk, weakening the EUR. Additionally, ECB failure to ease would likely depress risk appetite more broadly and spur further USD and JPY rallies across the board.
In contrast, an ECB ease would likely support risk currencies more than the EUR itself. Some investors would likely view the benefits to euro area credit risk from any ECB policy rate cut as more important than erosion of interest rate spread. This could boost EURUSD slightly. However, EURUSD has tracked German-US rate differentials more closely than credit risk measures over the past month, and even an aggressive ECB cut would not directly address the underlying drivers of European stress. We think the larger effect would be to support risk appetite more generally and as such, strengthen the periphery of the G10 and emerging markets against both the USD and the EUR. The SEK and PLN would likely gain against the EUR, assuming no offsetting negative news flow, while EURUSD and EURJPY would likely continue to edge lower. For further details on our views, please refer to FX Strategist – Policy easing in Europe: no quick fix.
GBP: Resuming QE. Our economists expect the Bank of England to restart QE with the announcement of a new ?50bn gilt purchase programme over a three-month period. The downward revision to UK growth earlier this week is likely to encourage the undecided within the monetary policy committee to lean towards further easing, in our view. However, we think there is a risk that the BoE may postpone the decision to November – sticking to its preference to announce major policy changes only in months in which the new Inflation Report is published.
We think resumption of asset purchases would likely hurt the GBP. In 2009, the GBP underperformed both the EUR and the USD by around 4-5% after the announcement of the first round of asset purchases, only to recover versus the USD when the Fed announced its own QE. We note that foreign purchases of gilts fell in August as markets began to shift expectations in favour of renewed QE. This was the first net selling since March and suggests foreign investors may react negatively to a new round of QE. With EURGBP capped by euro sovereign stress and reserve manager demand for reserve currency alternatives to the EUR, we prefer to express a bearish GBP view via GBPUSD shorts.
CAD: Softer PMI. Our economists project the Ivey PMI will fall from 56.4 to 53.5. The CAD’s gearing to global growth leaves it vulnerable to the possibility of another retracement in global risk appetite in the near term. We nonetheless remain constructive on CAD over the medium term and hold a 0.98 three-month USDCAD target.
CHF: Minimal inflation. We see a good chance that Swiss inflation in September will be lower than the 0.3%yoy consensus forecast. Even at the current 1.23 vs. the EUR, we believe the Swiss franc is still significantly overvalued and should keep inflation subdued in the foreseeable future. In its latest quarterly assessment, the SNB forecasts a period of deflation from Q4 2011 to Q3 2012. As such, we think EURCHF could rally if inflation surprises low.
The SNB’s FX reserve data for September will be a focus as the market attempts to gauge the extent of intervention required to enforce the CHF cap established in that month. However, we would caution that this release alone will not provide sufficient detail for us to infer the amount of intervention in the spot market in September. The changes in FX reserves can be attributed to three major factors: (1) net purchases of FX reserves, (2) valuation and market price changes in outstanding FX reserves assets, and, since August, (3) net FX forwards / swaps contracts (Exhibit 1). Today’s release will give only asset item 1 in the table below. Note that CHF15bn of the FX swaps the SNB had at end-August were of less than one-month maturity. To gauge the scale of FX reserve accumulation we will need to wait for the SNB balance sheet details scheduled for release at the end of the month.
What happened overnight
Risk-on, sort-of. Asian equity markets have rallied strongly in response to US and European news, but currency market price action has been more subdued. The Hang Seng index is up 4.3%, the KOSPI 3.8%, and the Nikkei 1.6%. However, EURUSD has traded slightly off of its overnight high to 1.333, and EURCHF, USDJPY and AUDUSD are essentially flat from Asian opens. USDKRW gapped lower to 1181.4, but has traded back up to 1190. Price action in most of the rest of Asia has been similar.
Overnight news about Europe has been a mix of statements from officials that point to a comprehensive program to augment European bank capital and questions about the potential for IMF involvement in buying European sovereign bonds. The FT has reported that the European Banking Authority will re-examine its stress tests to include haircuts to sovereign debt. The most constructive statements regarding bank recapitalization, in our view, have come from German Chancellor Merkel, who both acknowledged the need for these and the urgency for action. However, she currently appears to favor a program that would give banks more time to try to raise capital from the markets before they would then presumably be required to turn to their own governments for capital. At present, the earliest potential date for greater clarity on the issue is probably the 17/18 October Eurogroup meeting.
Less constructively, the IMF’s Europe director has had to retract a statement proposing IMF involvement in an SPV to buy euro area debt. This is because the IMF is currently only allowed to lend to countries directly. However, we think the fact that senior IMF officials are endorsing the idea of a vehicle to backstop the Italian sovereign is in itself positive, and we tend to think that if senior G20 officials decide IMF involvement in this process is desirable, the legal modalities will be worked around.
What to do
Go long SGD ahead of the MAS policy meeting
– We believe that risk-reward now favours going long the SGD ahead of Singapore’s central bank (MAS) policy announcement, expected the week of 12-14 October. The SGD nominal effective exchange rate (NEER) is currently about 1.1% above the bottom of the policy band, according to our estimates. We do not rule out that markets may re-test the lows, but we think current levels are attractive to begin building positions.
– We recommend the following ways to position long SGD:
– 1) Short USDSGD at current levels, targeting a move to 1.25 with a stop loss at 1.32. We estimate that the topside of the USDSGD policy band is about 1.319 currently.
– 2) Buy the SGD nominal effective exchange rate via a replicating currency basket containing the USD, JPY and EUR or the USD, JPY, EUR, and AUD.
– – A three currencies proxy basket, buying SGD against selling 17.3% EUR, 15.8% JPY and 66.9% USD, had an average tracking error of 0.20% and maximum tracking error of 1.13% over the sample period from January 2010 to April 2011.
– – 2) A four currencies proxy basket, buying SGD against selling 10.4% EUR, 16.6% JPY, 61.3% USD and 11.7% AUD, had an average tracking error of 0.17% and maximum tracking error of 0.82% over the sample period from January 2010 to April 2011.
– 3) Alternatively, given the high USDSGD implied volatility and strong positive spot/vol correlation, we recommend bearish USDSGD trades via short volatility strategies.
– Specifically, we recommend buying a two-month USDSGD 1.2750 put with a reverse knock out at 1.2475 for a net premium of 0.24% of the USD notional (spot ref: 1.3025). The structure is offered at a 77.4% discount to the 1.2750 vanilla put with a maximum leverage of 9.2x premium paid. The trade would reach its maximum potential if USDSGD trades just above the 1.2475 barrier at expiry (close to our three-month 1.25 forecast). If USDSGD trades through the barrier during the life of the option, the structure gets knocked out. The maximum downside on the trade is limited to the upfront premium.
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Credit Suisse
FIXED INCOME RESEARCH & ANALYTICS