To The Core
European fixed income markets remained under pressure on Tuesday, but the sell off was no longer confined to the periphery, in light of Moody’s outlook downgrade of Germany last night. While Italy and Spain 10y sold off by 11bp and 12bp respectively, bunds also sold off around 5bp. Unsurprisingly, this did little to console FX investors who continued their selling of euros versus most major currencies. PMI data added to the cautious tone. French July advance PMI show a mixed picture (manufacturing dropping to 43.6 but services jumping to 50.2) but German manufacturing PMI dropped sharply to 43.3. Services was also softer than consensus estimates. The service activity PMI has been below 50 for two months in a row, for the first time since summer 2009, and incoming business is also at the lowest since that period. UBS economics notes that as in France, the manufacturing index hit the lowest since the post-2008 slump, with new orders at very depressed levels – including foreign orders despite the weaker euro. A Spanish T-bill auction passed without incident with the treasury issuing at the upper range of estimates, though investors will find little consolation in this news, with the Spanish curve now also flattening very quickly. This is likely to have significant implications for future funding requirements, given recent funding has been at the cheaper part of the curve. USDJPY staged a brief rally after a MoF official championed the BoJ’s intervention policy and its success in capping JPY strength. This move later retraced however, in light of the softer risk appetite in wider markets. Earlier, Moody’s revised ratings outlooks for Germany, Holland and Luxembourg late during the US session to negative. Finland’s ratings were affirmed at AAA and the country did not suffer an outlook revision. Germany, having just regained ‘Outlook Stable’ with all three major ratings agencies just over six months ago, has lost this status again. Moody’s cited the risk of burdens falling on the most highly-rated states in the event of joint liability being assumed, and in doing so the pool of benchmark AAA assets (outlook stable and not on credit watch negative) has shrunk by more than half. The euro dropped on the back of the news but weak performance throughout Monday on the back of a return in sovereign fears had probably mitigated the impact of the ratings decision. Besides, it is hard to see Eurozone-based investors with a euro mandate pulling funds out of core Europe en masse. However, for non-Eurozone investors this only adds to the pressure to reduce exposure, especially with further benchmark rate cuts being priced in and the prospect of a proliferation in negative yields in countries with limited credit risk seriously affecting investor interest. In light of current Eurozone risks, we have moved our EUR exchange rate targets lower across the board. Our 1m EURUSD forecast is now at 1.20, and we still target a move to 1.15 by year end. Despite global growth risks, we shift our AUDUSD view higher to 1.00 in 1m and 0.97 in 3m. Firm data, sovereign buying and AAA-demand should keep the structural bid in place. Fed Chairman Bernanke speaks today at 12:45 GMT, while advance July PMI figures are due in Germany and across Europe.
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UBS Investment Bank