Thoughts at the End of a Tumultuous Week

This has been an extremely tumultuous week throughout the capital and commodity markets. August itself has been a cruel month. The German stock market has lost around a quarter of its value. A marked slow down in the US and Europe in Q2 has given rise double dip fears in the former and compounding difficulty achieving deficit targets in the latter. There are a number of take-aways for investors from this week's developments.

1. The euro remains very resilient. Many of the indicators that have often provided guidance into the euro's direction would suggest the euro should be weaker. These indicators include the euro's correlation with the VIX and the S&P 500, two-year interest rate differentials, which are at levels not seen since the start of the year, and the elevated basis swap.

2. The dollar funding crisis is becoming more acute. Not only did a member bank take dollars ($500 mln) from the ECB for the first time since Feb, but the SNB also activated its swap line with the Fed (took $200 mln). There is another force at work. The aggressive SNB action to stem the franc's appreciation has created arbitrage like opportunities. For example, those seeking to secure dollar funding, can borrow Swiss francs and swap into dollars easier and cheaper than securing dollar funding directly. Some of the pressure in the cross currency basis swap market may be attempts to secure such dollar funding indirectly. Both direct and indirectly seems to be pushing up dollar rates. Three-month Libor is at almost 5 month highs.

3. The ECB bought 22 bln euros worth of sovereign bonds in the first week of the resumption of its SMP operations. This is the largest weekly purchases and is almost a third of what amount the ECB has bought over the past year. There was a sharp drop in Greek yields when the ECB began its SMP operations, but the impact did not last long. Over the past week, Italian and Spanish 10-year yields were net-net little changed. Next week's data will help shed light on whether the ECB purchases have reached the point of diminishing returns.

4. The Troika (IMF, EU and ECB) visit Greece next week to evaluate the progress toward meeting the conditions to allow the next tranche of the 2010 aid program. As we saw previously, this poses event risk as the weaker growth performance (and projected) makes the fiscal targets more difficult to achieve. In a larger sense, the dispute over Greek collateral points to a still laborious process approval of the second Greek aid package.

5. The more successful the SNB is to break the one-way franc appreciation (and they cannot be too displeased with the success achieved thus far of almost 15% depreciation vs the euro and this week's range of CHF1.1045-CHF1.1555), the more pressure on the Japanese yen, the other major safe haven and net international investment creditor. Foreign investors purchased a record amount of Japanese bills (almost JPY3 trillion) in the week through Aug 12. Japan is no longer the low interest rate country. Switzerland is. Swiss interbank rates are negative going out 6-months and its 2-year bond is yielding -13 bp. Fear of a double dip in the US and the Fed's commitment to keeping rates low for at least the next two years has pushed the US-Japanese 2-year spread to the lowest levels--almost parity--since the early 1990s.

6. Foreign investors have been large sellers of Asian shares this month, but over the past week, there has been some stabilization. Foreign investors were actually net buyers this week of Philippines, Korean and Vietnamese shares, according to the respective exchanges. However, over the course of the month, foreign investors has sold $4.6 bln of Korean shares and almost $7 bln of Taiwanese shares, which accounts for the lion's share of this year's liquidation. Weekly MOF data shows foreign investors have sold about $10 bln of Japanese shares, through Aug 12.

7. Given the equity market weakness and heightened growth worries, Latin American currencies have also been more resilient than one would have had reason to expect. The Brazilian real is up 1.1% on the week, while the Colombian and Mexican pesos are about up about 0.5% as today's session gets under way.

8. China has made some promising indications of plans to make it easier for offshore yuan (CNH) to be used to purchase investments in the mainland (CNY). Initial signs suggest modest amounts will be allowed at first, which is typical of China's modus operandi. This is the direction that will please global investors. It will also help address the imbalance between the size of the Dim Sum market and the accumulation of CNH deposits.