Barclays: We are extremely cautious about risk taking on exchange rate markets
Last Updated on Monday, 24 October 2011 11:16 Written by Barclays Capital Global Research Monday, 24 October 2011 11:13
The European Council meeting on Sunday 23 October offered few details about the key issue of EFSF leverage, Greece haircuts, and bank recapitalizations. This is broadly in line with our expectations that the news coming out of this meeting would not be a 'game changer' for the markets. Most of the details will likely be discussed more thoroughly at Wednesday's summit.
On the issues of EFSF leverage, however, comments from German officials suggest that Germany and the ECB have ruled out plans to leverage the EFSF via the ECB, which was France's preference. Berlin is instead considering the possibility of the IMF helping Italy and Spain if they require liquidity.
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Using the ECB to leverage the EFSF was a potential near-term risk positive given that the ECB's fire power cannot be matched by other financial institutions in Europe.
One less reason for an exchange rate related risk rally
The lack of involvement from the ECB, all else equal, means that there is less scope for a risk rally. Together with our view that the euro area issues will persist even after corrective measures are taken, we remain extremely cautious about risk taking in FX, both into the Wednesday summit and beyond. Overall, we continue to believe that the damage to the euro-area growth outlook has already been done and that this will weigh on the euro via easier monetary policy by the ECB at a time when US data are showing signs of positive cyclical momentum.
Investor concerns about bank de-leveraging likely to persist
We expect an overall mood of caution towards risk currencies (both G10 and EM) given the paucity of news or agreement out of the EU summit.
There were few concrete proposals on European bank recapitalisation - the one area where some news had been anticipated. This leaves open a potential scenario of European bank deleveraging as European institutions try to reach new capital adequacy ratios within a defined period (6-9 months according to an FT report).
Unless there are conditions against loan book reduction, the process of getting to the new capital adequacy ratios could have negative implications for countries with large external funding needs. This would likely impact the EEMEA region, notably those countries which have historically met these needs by borrowing from European banks.
We look for the higher volatility EM currencies and those of the EEMEA region to come under the greatest pressure over the next few days.
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