Investors could fade the latest rally in risk sentiment

23/02/09 21:21
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Ref: UBS, Bloomberg

The US dollar rallied and equity markets fell as risk aversion rose again on bank nationalization fears. The US Treasury, FDIC, OCC, OTS, and Federal Reserve issued a joint statement stating that the stress test on the banking system will begin on Feb 25 and indicated that they would prefer not to have to nationalize banks. Should the stress test not have been done five years ago, or more? Fed Chairman Bernanke is scheduled to deliver his semi-annual monetary policy report testimony before the Senate Banking Committee in the US session. We anticipate that he will indicate rates will remain low & for some time." He will probably be challenged for a comment on the government nationalizing U.S. banks, as well as any specific details on the "stress tests" that some U.S. banks will soon undergo. The market will likely react to any unsettling verbiage from the masters who created the mess. Probability weighs in favor of further negative news on the state of the economy, which will continue to jack up the world reserve currency.


We maintain a positive outlook on the dollar as we think investors could fade the latest rally in risk sentiment, as we have noted here. The bank nationalization plan could take time to be implemented and with details still uncertain, investors will likely continue to tread cautiously. The US is by far not out of the woods but the market is currently receptive to actions by the Treasury and Federal Reserve, and neither is there any sign that buyers of US debt will abandon the market in the immediate future. In talks with US Secretary of State Hilary Clinton over the weekend, China public expressed confidence in US Treasurys and any moves on Beijing's part to diversify will likely be gradual and undisruptive. UBS analysts suggest to hedge the view of either a risk rally or a debasing of the US dollar with a 6-month call option on the AUD.

Ahead today, Fed Chairman Bernanke testifies at 1500 GMT.

The EU leaders' summit held over the weekend concentrated on broader issues of economic recovery and financial regulation, disappointing observers which had hoped some concrete initiatives would be announced. Italian Prime Minister Silvio Berlusconi confirmed that leaders did not talk about a Eurozone bond and the issue has been set aside left with Eurozone Finance Ministers to deal with. Regarding the joint Eurozone bond issue, just how this will be done is still not clear but we long hold the view that any such event would only prove to be a short-term positive for the EUR, as any move to defend weaker states would come at the expense of risk premiums for stronger states. On Friday the German foreign minister said that a process had begun to consider how Eurozone countries in stronger financial positions could provide assistance to those more in need. This could root out the degree of solvency some banks maintain, which will represent risk. Nevertheless, Steinmeier repeated Chancellor Merkel's warnings that currently there are no specific targets and speculation would be unnecessary. It appears that Germany still wants to work under the G20 framework for any action to have maximum effect and a senior German official also commented overnight that the G20 will have a look at the banking sector in Eastern Europe, but the stability of the EUR was not in question. On the data front however, disappointments returned as the PMI manufacturing and services both disappointed expectations. At 32.2 (cons.32.5) the expansion in manufacturing PMI was smaller than expected while services PMI fell sharply to 41.6 from 45.2 previously. This week will see more crucial releases for the Eurozone, including zone-wide price indices and confidence indicators. The German Ifo will be released today and markets are hoping that some signs of bottoming out can be seen, but judging by Friday's PMI releases we see little scope for optimism as slumping global demand continues to hit industry. The Eurozone remains behind the crisis curve and given the bank risk discussed in previous commentary, forecast for EUR is lower, with risk being an event of any major USD positive events, which are not foreseeable, at present.

The preliminary Q4 GDP estimate will be out on Wednesday and markets are looking for a 1.6% decline in growth (1.9%y/y). With private consumption and trade figures all set to register declines, the numbers will add impetus to the BoE's drive to begin quantitative easing as soon as possible. Housing data will also be out this week and the Nationwide House Price index will likely show further deterioration in the housing market as prices are set to show a 17.1% annualised fall. The UK still looks set to be the first G10 country to commence quantitative easing and despite the BoE's clear intentions the market is not willing to price in a sharp decline in the pound. Credit deflation is still a pressing problem in the UK and the BoE itself is still doubtful over the efficacy of attempts at monetary expansion. We remain cautious on chasing excessively sterling weakness.

Ref: UBS, Bloomberg

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