Dollar Bounces Back, Pessimism Persists in Europe

The US dollar is broadly firmer, with the recovery of the yen the only main exception. The key fundamental drivers are the recognition that this week’s EU Summit is unlike to resolve the protracted debt crisis and that the Federal Reserve seems restrained compared with the actions of the ECB and BOE. 

Growth and policy concerns have weighed on global equity prices. The MSCI Asia Pacific Index is off 0.6%, led by a 1.6% decline in the Shanghai Composite to new 5-month lows, on weaker growth fears, with industrials and basis materials the weakest sectors. New measures to encourage foreign investment in India helped stabilize the rupee but did little for the stock market which lost about 0.5%. 

In Europe, the Dow Jones Stoxx 600 is off around 1% near midday in London, with the financials the worst performing sector. Peripheral bond yields are higher. Spanish and Italian 10-year bond yields have retraced a quarter of last week’s gains and pressure at short-end (2-year) is even greater than on the long end.

Spain’s request today for funds to help it finance the recapitalization of its banks is simply a formality. The key, which will be worked out over the next two weeks and codified into a memorandum of understanding, is the rate and conditions attached to such aid. 

There were two other developments over the weekend that are more significant.  First, Italy’s third largest bank Monte dei Paschi and the only one seen to still be facing a sizeable capital shortfall ahead of the end of the month deadline by the EBA, may seek a government guarantee for at least 1 bln euro bond. 

While there is some stigma associated with this course, it will be cheaper than the alternative, such as a contingent convertible bond. Ironically, unlike in Spain, where the banks are undermining the sovereign, in Italy, it is the other way around. Monte dei Paschi owns proportionately more government bonds than the other large Italian banks.

Second, in order for Merkel to secure support for the ESM and fiscal pact from the German states represented in the upper house of parliament, she relented on a long-term position: Starting next year, there will be joint federal and laender (state bonds). The details of these “Deutschland bonds” are not clear. Eligibility, amount and cost were not announced. 

Yet, the fact that they will exist is the important point now. Germany did not just refuse to share its balance sheet with its neighbors; it had refused to share it with its own states, which enjoy an explicit guarantee. This agreement in Germany can be a model for the Spanish government that is trying to impose fiscal discipline to its more regions. It may also be somewhat suggestive of what may be necessary to have joint euro bonds.

Before the weekend, the ECB relaxed its collateral rules. This is not just a technicality, but is important. It is an unconventional form of easing. Access to credit will be enhanced by the ECB’s decision. For some European banks access (to funding) is just as important, if not more so, than price. Reports suggest that Spanish banks may be among key beneficiaries of both the ECB’s acceptance wider range of types of collateral and lower credit quality. A number of other decisions during the crisis, including the sovereign bond purchases and the previous lowering of ECB lending standards, have taken place over German objections.

This is also noteworthy and casts doubt over observers who argue that Germany is dictating the euro area’s policy response. Although the cost of swapping from euros to dollar has risen only marginally in recent weeks, there are other signs that tensions may be rising. The Federal Reserve reported an increase in the ECB’s use of the dollar swap line, demand has risen sharply for ECB funds at its weekly operations, and the commercial paper issued by European banks in the most recent reporting period fell at the fastest rate since last February. 

Sentiment toward the yen has soured as Prime Minister Noda secured opposition support for the retail sales tax hike. The process leading to parliamentary approval will reportedly begin tomorrow. The yen bears argue that if it passes, the BOJ is more likely to increase its asset purchases to offset the fiscal drag. If it does not pass, Japan’s rating may be downgraded. We are not persuaded, though technically, we see the dollar having scope additional near-term gains. 

First, the general risk climate seems a more important driver of the yen than domestic developments. Second, the first stage of the tax hike would be implemented in April 2014. This is unlikely to impact near term BOJ decisions. Third, neither quantitative easing nor rating agency downgrades have been key drivers of the yen. Some would argue that the mid-Feb unexpected increase in asset purchases did weaken the yen, but it also corresponded to the large risk-on environment fueled by the two LTROs from the ECB. Separately, we note that the BOJ is struggling to find sufficient offers for it asset purchase plan (in eight consecutive attempts).