Euro Recovers After S&P Slam

The euro sold off amid the rumors of the S&P decision to put on credit watch 15 euro zone countries.  Spared was Greece, in a world of its own, and Cyprus, which was already on credit watch.  It sold off further in Asia, but Europe has shrugged it off and, with the help of a monster manufacturing orders report from Germany has fully recovered from the drop that took it to a 4-day low of about $1.3335.  Offers are seen in the $1.3430 area now. 

German manufacturing orders jumped 5.2% in Oct, more than six times more than the consensus expected and completely reverses the 4.6% decline in Sept.  Domestic orders still point to a softening of the economy and were up 1.4%, but the foreign orders posted a dramatic increase of 8.3%.  Foreign demand for capital goods was especially pronounced, jumping 12.2%, while overall cap goods orders were up 7.8%.    The euro zone economy may be recession bound and Germany may have slowed down, but it remains a pocket of strength and that helped risk appetites. 

There is not much to be said about the S&P decision.  There is a logic to it and clearly tail risks have increased.  Among the reasons cited were tighter credit conditions.  Ironically credit conditions have eased considerably.  Note that the 3-month cross currency swap is at 115.5 below Euribor down 42 bp since Nov 30.  Overnight deposits at the ECB fell yesterday for the first time in two weeks, though still elevated. 

The ECB sterilized in full the amount of sovereign bonds it has purchased.  Last week recall the ECB failed to do so and many observers raised questions of intent and even that it was covert QE.  As we noted at the time, these assessments were wide of the mark.   

It is similar to the recent bund auction that was not covered.  The market exaggerated the implications.  Not only were other recent auctions under subscribed, but there is no real flight of capital from Germany as the negative bill yields continue to show and for two days last week, German 1-year note yield was negative. 

Swiss reported a 0.2% decline in consumer prices, bringing the year-over-year rate to -0.5%.  There had been some speculation that the SNB will lower the franc's cap.   We are not convinced.  To raise the euro floor to CHF1.25 from CHF1.20 is too small of a move and it is already near CHF1.24.  To raise it to CHF1.30 risks the already achieved success and could be most costly.  Realpolitik and game theory suggests, it seems, strategic ambiguity is doing a good job at a reasonable cost.  The almost CHF16 bln drop in reserves was attributed by the SNB to the maturing of FX swaps and repos. 

S&P also cited greater risk of recession and continued disagreement among policy makers.  Their facts seem right, but its the judgment and timing that concerns many.  Moreover, in a much overlooked decision yesterday Merkel and Sarkozy agreed to allowing ESM decisions based on a qualified majority rather requiring unanimity.   In general, and especially following the error report recently that it had downgraded France and the fact that both in the US downgrade on Aug 5 and yesterday's move was in the market well before the official announcement is not going to bolster the rating agencies perceptions in the market or by officials. 

The Reserve Bank of Australia as widely anticipated cut rates 25 bp.  The next meeting is in February and another cut, the third in the cycle is likely.  Australia still has the higher rates among the G10 and will even after a Feb cut.  China has already eased policy and it is only the first move.  We look for other countries in Asia to ease as well in the coming months. 

There is one main highlight for the North American session today.  The first is the Bank of Canada meeting.  It is not expected to do anything.  The focus is more on the statement.  A rate cut would be a negative surprise for the Canadian dollar.  The more likely risk is a dovish statement.  From another perspective, the risk of AAAs in Europe being cut, Canada may be an attractive AAA alternative.  The US dollar appears capped in the CAD1.0220 area.  A break of it trigger another 0.5% gain.