FX Update and Adjusting to Zero Deposit Rate

The US dollar is trading little changed against the major currencies, but the dollar-bloc currencies are a bit better bid, perhaps encouraged by China's data, which on the face of it was not as poor as feared when PBOC cut interest rates earlier this month.   Q2 growth was 1.8% quarter-over-quarter, up from a revised 1.6% in Q1.  Year-over-year growth slowed to 7.6% from 8.1%.  Retail sales and fixed asset investment were a bit stronger than expected while the 9.5% year-over-year increase in industrial output was a bit softer than expected. 

Global equities ar mostly firmer.  The MSCI Asia Pacific Index rose almost 0.5%. Most European bourses are higher, with the Dow Jones Stoxx 600 up around the same, with financials the weakest sector.  Italian and Spanish markets are under-performing.  

The euro and sterling will begin the North American session on a firm note, but short-term momentum indicators may get stretched quickly.  Although a stronger cap is near $1.2250, the recent pattern has been for euro bounces to fall shy of technical resistance or retracement levels.  This suggests sellers may re-emerge in the $1.2220-50 area.    

Sterling resistance is seen in the $1.5500-20 area, but the bears may begin making a stand in the $1.5465-80 area.  The Aussie has bounced from $1.01 yesterday to $1.0185 today.  Intraday technical studies warn it may struggle to sustain this momentum.  Sellers may be seen in front of $1.02 as the recent string of poor data encourages speculation of a rate cut as early as next month.   

The greenback is near the lower end of its three week range against the yen near JPY79.20.  Ten-year JGB yields fell earlier today to their lowest level in a couple of decades, but at 70 bp the differential with the US may be too low to draw much investment interest.  Note that the decline in US yields and flattening of the curve risks undermining the key driver of Japan's current account surplus--the investment income balance. 

The implications of the ECB's zero deposit rate are still being digested.  Some euro money market funds have announced closure, or closure to new investors.  Money market funds were previously a source of short-term funding for banks.  Banks themselves dramatically reduced their overnight deposits at the ECB.  The zero deposit rate was effective as of Wednesday, the beginning of the new reserve period.  Overnight deposits fell from 800 bln euros on Tuesday to 325 bln euros on Wednesday before stabilizing yesterday (366.2 bln euros).  EONIA traded a little above 32 bp as recently as Tuesday, before falling to 13 bp on Wednesday and stabilized just below there yesterday. 

Some observers tried linking the euro's decline to the drop in overnight deposits.  However, a closer look shows that banks simply reallocated the funds to a different account at the ECB (current account).  The current account balance is used to meet the monthly reserve requirement.  Banks get paid the refi rate (now 75 bp) on their funds needed for their legal reserve requirements (currently estimated around 107 bln euros).  Excess amount is in this account do not earn interest.  With the deposit rate at zero, banks may be indifferent to holding overnight deposits or current account balances.  

The overall money at the ECB (current account balance plus deposit facility minus the reserve requirement) is little changed.  This does suggest an operational challenge should the ECB cut the deposit rate below zero, as say Sweden's Riksbank did earlier in the crisis.  A negative deposit rate would encourage banks to shift even more of excess reserves to the current account and away from the deposit facility. Lastly, following the imbalances in the euro area, including Target 2, it appears peripheral banks are net borrowers from the ECB, while the Northern European banks are net depositors there.  That means that impact of zero deposit rates impacts Northern banks more than peripheral banks.

Italy's bond auction of a new three-year bond was  well received, (though the off-the-run sale did not see the same enthusiasm giving rise to some talk of a single large buyer for the new issue) despite the poor backdrop given Moody's two notch downgrade of the sovereign rating to Baa3 from A3.  This puts Moody's rating below S&P and Fitch and it kept a negative outlook.  Moody's said that Italy is now more susceptible to political risks, such as a Greek exit, for which it thinks the risks have increased, or Spain requiring more aid.  It also noted the diminished overseas investment base.  Italy's 10-year yield is up about 11 bp near-midday in Rome, but the 2-year yield is a few basis points lower.   

Turning to Spain, Economic Minister DeGuindos indicated that Spain is liable for future loans to its banks and that the "creditors will not suffer the slightest loss."  He said that Spanish banks need a maximum of 62 bln euros to finance restructuring, but has asked for 100 bln to ensure a buffer.   Meanwhile, although the EU relaxed Spain's fiscal targets, Spanish regions know no such reprieve.    This year's deficit target of 1.5% is unchanged.  Next year's target was increased to 0.7% from 0.5%, but the 2014 target was cut to 0.1% from 0.3%.  Reports suggest several regions, controlled by the PM Rajoy's PP, voted against the new deficit limits and a couple abstained, which plays on investors' skepticism the fiscal discipline on the regional level.