After S&P US Downgrade, ECB response narrows Italian-German bond spread significantly.
Markets will test ECB’s commitment.
FOMC statement, China data, are other main event risks. Latter could grant a reprieve from further AUD sell-off.
After seeing trading in both Asian and early European sessions, the FX market response to the S&P downgrade of the US appears consistent with our expectations. Namely, the “risk-off trade” continues pushing commodity-linked currencies lower and the USD higher. USDJPY and USDCHF continue to push lower while the EUR remains caught amid concerns over the eurozone bond market and weak US economic prospects.
After the Italian governent announced that it would accelerate plans to balance its budget, the ECB Governing Council met yesterday and said that it would ‘actively implement’ the Securities Market Programme (SMP) of bond-buying. Since the European open, 10-year Italian yields have fallen sharply from well above 6% last week to 5.35% today. Italian spreads over Germany have narrowed by almost 100 bps to 297 bps. Such action is exactly what financial markets were seeking and explains the bounce in EURUSD from Friday’s low of 1.4054.
Still, early EURUSD price gains have not been sustained, suggesting that evidence of the sustainability of such action is needed. A German government spokesman has noted that the ECB is acting independently and has played down suggestions that the size of the EFSF will be increased. We acknowledge that near-term risks may still arise but note two important factors 1) the ECB decision to curtail the substantial widening of Italian spreads should be decisive in keeping market fear at bay and 2) European governments’ commitment to doing what is required to stabilise debt markets will bolster chances for EUR appreciation. As markets test the ECB comittment to maintaining discipline in bond markets over coming sessions, EURUSD trading may be choppy but ultimately our opinion is that downmoves in EURUSD are likely to prove excellent mediuem-term buying opportunities.
We are much less convinced about protection of a floor under USDJPY and if intervention does turn out to be a one day wonder, we have little doubt that USDJPY will seep lower again, eventually back through last week’s Y76.30 low.
Eurozone developments aside, much will depend here on whether Tuesday’s FOMC meeting does enough, via a strengthening of the commitment to – and longevity of – current policy settings and (though much less certain) expression of willingness to contemplate additional actions if warranted, grants risk markets enough of a reprieve from last week’s carnage to see the USD leak lower again. This morning’s G7 statement held out the prospect of coordinated intervention in the event of a disorderly move in markets; but at the same time professed that exchange rates should be set by the market. We do not see this as providing support for Japanese intervention on a orderly decline in USDJPY.
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