Morning Commentary: Checking Under the Hood

Foreign Exchange - Morning Commentary
Checking Under the Hood
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Andrew Kositkun
Andrew Kositkun
Foreign Exchange Head Trader
The COVID-19 crisis has hit the Eurozone periphery particularly hard and exacerbated preexisting imbalances.  This point is proven by government debt-to-GDP data that shows a sharp increase in Eurozone periphery debt from already elevated levels. 

Some in the markets are hoping that the EU Recovery Fund sets a new precedent on how Europe will address debt risks, but there are reservations around this.  Legally, the EU Fund is part of the EU budget.  This means it’s a one-off response to a pandemic.  Certainly a similar approach can be used to address future common shocks, but it is far from certain that this approach will be used to address country specific shocks—including individual country debt sustainability concerns. 

Beyond debt issues, the Eurozone continues to suffer from the lack of a banking union.  While markets are not currently focused on banking issues, they have not gone away.  For example, there still is not a Eurozone-wide bank deposit insurance, a critical weakness that contributed to the Eurozone debt crisis a few years ago.  Upon recognition that the bank deposit insurance from a bankrupt Eurozone government was ineffective, you had deposit flight in one peripheral country triggering deposit flight in other peripheral countries. 

If the markets see a euro in one Eurozone country’s banking system as less attractive as a euro in another Eurozone country’s more stable banking system then the single currency’s ability to function as a stable store of value gets eroded. 

This is of particular concern due to the persistent discrepancies in asset quality in the Eurozone.  Within the advanced economies, all of the countries with above average non-performing loan (NPL) ratios are Eurozone members.  Within this, the Eurozone periphery countries look the worst even if you exclude Greece which is the outlier with by far the largest NPL ratio.  It is reasonable to expect these NPL ratios to get worse as the pandemic has hit these periphery countries especially hard. 
HERE ARE THE KEY NEWS STORIES FROM OVERNIGHT:
  • The USD dropped to a two year low, more than 10% below its March highs.  While the USD index is down, USD losses have been more pronounced against European currencies while its performance has been mixed against emerging market and Latam currencies.  Commodity and gold prices are moving up, as normally happens during periods of dollar weakness. 
  • US ISM manufacturing PMI beat expectations at 56.0 versus expectations for a 54.8 print.  The new order component had a strong beat at 67.6 versus expectations for a 58.8 print.  Additionally, the employment component ticked up to 46.4 from 44.3 but remains in contractionary territory.  Tomorrow brings the ADP employment report with the government’s jobs report out this Friday. 
  • The Reserve Bank of Australia kept its cash rate and 3 year yield target unchanged as expected.  The bank also noted that the virus outbreak and related lockdown are “having a major effect on the Victorian economy.”  The bank also confirmed that it would not raise rates until progress was made towards full employment and inflation is sustainably within its 2-3% target band. 
  • Eurozone CPI fell by -0.2% YoY.  This was a larger than expected drop and the first time inflation has gone negative since 2016.  The unemployment rate rose to 7.9% from 7.8% but beat expectations for a rise to 8.0%.  This rise in unemployment was expected as manufacturing PMI data showed factories cutting jobs and reducing inventories. 
  • Wage data is being skewed by pandemic-related job losses.  Wage data showed a 10% increase in the median weekly earnings but this happened due to low income workers losing their jobs and not due to wage increases per a study by Mary Daly, President and CEO of the Federal Reserve Bank of San Francisco.  As such, the jobs recovery should be a drag on wages.
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