FX Drivers

The main driver today is fear that the European debt crisis is spreading to Spain. Three developments in the past couple of days have put Spain in the market’s cross-hairs. First, the Spanish central bank had to take over a savings bank over the weekend. Second this was followed yesterday by 4 other savings banks merging. Third, the IMF yesterday urged Spain to do more to overhaul its banking system warning that its response has been too slow. It also commented on some of its structural rigidities, as in the labor market.

In addition to its much larger size, Spain also differs from Greece in that the bulk of Spain’s debt issue is not (yet) a sovereign issue as it is in Greece. As in Portugal, the debt is still largely a private sector issue. However, all share that common trait of requiring external financing.

Late last week the market was debating whether the ECB had intervened to support the euro. Today the concern is that some central banks may be diversifying away from the euro. Indeed there is market talk today of some euro sales being reported from by an international entity often seen as an agent of European central banks.

Some talk has centered on the Swiss National Bank, which is believed to have accumulated billions of euros in its intervention. However, we are skeptical that the SNB would sell the euros in the spot market. This would seem to be counter-productive.

Nevertheless as previously noted the Russian central bank, a critic of the dollar and its role in the world economy a year ago has indicated that it has reduced the euro’s weighting in its reserve holdings. Today, Nigeria, with only 15% of its reserves in euros, also suggested it would reduce its holdings if the single currency continued to fall.

News that North Korea has put its military on heightened state of alert weighed on South Korean markets and may have also encouraged dollar and yen buying. Of note, however, gold was not seen as a safe haven. Indeed, gold, like other commodities, is trading heavily.

The Korean won fell to 10-month lows against the dollar. The 3% decline today is the largest since last March. It had been down when the news first broke. Separately, we note that South Korean banks have relatively high levels of foreign currency exposure and the liquidity squeeze that has seen LIBOR double in recent weeks. Another channel that is weighing on Korea is the foreign sales of shares. During the first four months of the year, foreign investors had bought roughly $10 bln worth of Korean shares. This far this month, they have liquidated more than half of this.

Economic data in this environment has meant little in terms of immediate price action, but are still noteworthy for the larger macro-economic picture. First, Fonterra, New Zealand’s milk coop and largest business accounting for around 6-7% of GDP boosted its projected price for the FY2010-2011 period to NZ$6.90-NZ$7.10, from around NZ$6.50 in FY2009-2010. This is generally a positive for New Zealand.

Second, the UK revised Q1 GDP slightly higher to 0.3% form 0.2%, as widely expected. The details were poor. Private consumption, for example, which had risen 0.4% in Q4 09 was flat. Government spending rose 0.5% after a 1.0% rise in Q4.

For those who think that a weaker currency has helps boost UK exports, unlike say Greece, which cannot depreciate, take a close look at UK exports. After rising 3.8% in Q4, they were flat in Q1. Imports rose 1.4% in Q1, after rising 4.7% in Q4. However, one bright spot was gross fixed capital formation, which rose 1.5% after a 2.7% drop in Q4.

In the euro zone, two reports stand out. The first is Italian retail sales for March. The 0.5% increase was well above consensus expectations and this lifted the year-over-year rate to 2.9% from -0.4% in Feb. Note that an early Easter has generally played havoc with the March-April retail sales reports. The second and more promising report is the industrial orders data for the euro zone. The 5.2% increase was more than twice the consensus and the Feb series was revised to 1.9% from 1.5%. The year-over-year rate rose to 19.8% from a revised 12.5%. Of course the heightened anxiety and disruption of the capital markets calls into question the economic implications of this data but the overall point is that after a weak start to the year, the euro zone economy as a whole appeared to be picking up prior to the eruption of the financial crisis.