Regional FX & Fixed Income Strategy

  • Czech FX: Despite growing media speculation to the contrary, the Czech National Bank opted not to launch FX interventions following the Czech National Bank's September 26 board meeting, in line with our expectations. With a recovery in economic activity starting to take hold across Central Europe, we maintain that direct FX interventions by the central bank remain unlikely unless the koruna starts to strengthen towards the CZK24.00/EUR level.

  • Ukraine CDS: The risk of an all out trade-war with Russia in retaliation for signing the EU's association agreement in November risks pushing Ukraine's already vulnerable economy towards economic collapse. Ukraine's 5 year CDS spread opened 45 basis points higher than last week, at 1104bps, and a combination of a large current account deficit, low FX reserves, unrestrained government spending, extortionate borrowing costs and difficulty in accessing external financing all point towards a high risk of currency devaluation and/or default over the coming months.

  • Romania FX: With a higher proportion of Romanian local debt now under foreign ownership (27.8% in June), we believe investor appetite for the country's local debt will determine the future trajectory of the RON over the next few months. We now see potential for the leu to continue weakening over the coming months, as we expect the National Bank of Romania (NBR) to continue its interest rate cutting cycle, pushing down yields on local debt and modestly reducing demand for the currency.

  • Serbia FX: With the Serbian dinar trading at RSD114.95/EUR at the time of writing, we expect to see the unit edge towards RSD114.25/EUR level over the next couple of months. The main driver of a stronger dinar over this time frame should be the US Federal Reserve's September 18 decision to delay the tapering of its current quantitative easing programme as well as the gradually improving external and fiscal positions of the country as well as active FX intervention by the National Bank of Serbia (NBS).

  • Italy CDS: Although we now see political risk as being more adequately priced into Italian credit markets following the collapse of Prime Minister Enrico Letta's Cabinet on September 28, we see the potential for further gains in our Spain-over-Italy 5-year credit default swap view as several more days of uncertainty lie ahead before any sort of clarity emerges regarding the future of the government ( see below).

Our Spain-over-Italy 5-year credit default swap (CDS) view, initiated on July 31, was underpinned by our belief that political risk in Italy was inadequately priced into fixed income markets. However, political instability is now at the forefront of media and financial market attention following the resignation of five cabinet ministers from Silvio Berlusconi's Forza Italy (FI) Party on September 28. Furthermore, the recent escalation of political tensions has served to highlight Italy's deteriorating fiscal position, a second factor motivating our view. Together, this implies to us that previously under-accounted for risks will now be largely priced in, and with the spread reaching 41 basis points at the time of writing, we are awaiting the right opportunity to exit our view with maximum gains.

However, with a confidence vote scheduled for Wednesday that will determine whether fresh elections are necessary, we see the potential for several more days of uncertainty to weigh on investor sentiment and continue to push the spread higher. Although the cost of hedging against the risk of a eurozone member state credit event is still susceptible to political risk, as evidenced by recent events, it will be fundamentally capped by the European Central Bank's bond buying programme and pledge to do whatever it takes to protect the currency union. As such, we believe the spread will stabilise once clarity emerges regarding the future course of political events, with the potential for a modest retracement should Letta manage to avoid elections and cobble together a new coalition with FI defectors.

Political Risk Driving Spread Higher
Spread Between Italy and Spain 5-Year Credit Default Swap (CDS), basis points
  • Czech FX: Despite growing media speculation to the contrary, the Czech National Bank opted not to launch FX interventions following the Czech National Bank's September 26 board meeting, in line with our expectations. With a recovery in economic activity starting to take hold across Central Europe, we maintain that direct FX interventions by the central bank remain unlikely unless the koruna starts to strengthen towards the CZK24.00/EUR level.

  • Ukraine CDS: The risk of an all out trade-war with Russia in retaliation for signing the EU's association agreement in November risks pushing Ukraine's already vulnerable economy towards economic collapse. Ukraine's 5 year CDS spread opened 45 basis points higher than last week, at 1104bps, and a combination of a large current account deficit, low FX reserves, unrestrained government spending, extortionate borrowing costs and difficulty in accessing external financing all point towards a high risk of currency devaluation and/or default over the coming months.

  • Romania FX: With a higher proportion of Romanian local debt now under foreign ownership (27.8% in June), we believe investor appetite for the country's local debt will determine the future trajectory of the RON over the next few months. We now see potential for the leu to continue weakening over the coming months, as we expect the National Bank of Romania (NBR) to continue its interest rate cutting cycle, pushing down yields on local debt and modestly reducing demand for the currency.

  • Serbia FX: With the Serbian dinar trading at RSD114.95/EUR at the time of writing, we expect to see the unit edge towards RSD114.25/EUR level over the next couple of months. The main driver of a stronger dinar over this time frame should be the US Federal Reserve's September 18 decision to delay the tapering of its current quantitative easing programme as well as the gradually improving external and fiscal positions of the country as well as active FX intervention by the National Bank of Serbia (NBS).

  • Italy CDS: Although we now see political risk as being more adequately priced into Italian credit markets following the collapse of Prime Minister Enrico Letta's Cabinet on September 28, we see the potential for further gains in our Spain-over-Italy 5-year credit default swap view as several more days of uncertainty lie ahead before any sort of clarity emerges regarding the future of the government ( see below).

Political Risk Driving Spread Higher
Spread Between Italy and Spain 5-Year Credit Default Swap (CDS), basis points

Our Spain-over-Italy 5-year credit default swap (CDS) view, initiated on July 31, was underpinned by our belief that political risk in Italy was inadequately priced into fixed income markets. However, political instability is now at the forefront of media and financial market attention following the resignation of five cabinet ministers from Silvio Berlusconi's Forza Italy (FI) Party on September 28. Furthermore, the recent escalation of political tensions has served to highlight Italy's deteriorating fiscal position, a second factor motivating our view. Together, this implies to us that previously under-accounted for risks will now be largely priced in, and with the spread reaching 41 basis points at the time of writing, we are awaiting the right opportunity to exit our view with maximum gains.

However, with a confidence vote scheduled for Wednesday that will determine whether fresh elections are necessary, we see the potential for several more days of uncertainty to weigh on investor sentiment and continue to push the spread higher. Although the cost of hedging against the risk of a eurozone member state credit event is still susceptible to political risk, as evidenced by recent events, it will be fundamentally capped by the European Central Bank's bond buying programme and pledge to do whatever it takes to protect the currency union. As such, we believe the spread will stabilise once clarity emerges regarding the future course of political events, with the potential for a modest retracement should Letta manage to avoid elections and cobble together a new coalition with FI defectors.

BMI Europe Asset Class Strategy
DATE INITIATED ENTRY LEVEL GAIN/(LOSS) * RATIONALE
Source: Bloomberg, BMI
CURRENCIES
NA
FIXED INCOME
Spain over Italy 5-Year CDS 31-Jul-2013 1bps 41 bps Italy's political and fiscal position to deteriorate, chance of coalition collapse. Spain moving along improving trajectory, Rajoy government likely to survive.
EQUITY INDICES
Eurozone Over US Equities (Ratio of MSCI US to MSCI EMU) 15-Aug-2013 17.3 2.4% Though we still like the US, eurozone underperformance has reached extremes, and the eurozone economy is picking up momentum. The MSCI EMU looks attractive on a technical basis and is increasingly cheap versus the US. Targeting a move down in the US/EMU ratio to 14.0x.
Bullish ISEQ Index 13-Aug-2013 4,230 0.5% Successful EU/IMF bailout exit looking likely, Fine Gael/Labour Coalition comitted to austerity, improving consumer sentiment and growth outlook, reduced proportion of financials on index, house prices stabilising, strong technical picture.
Bullish Spanish Small Caps (IBEXS) 13-Sep-2013 4,000 7.9% Cheap valuations, competitiveness gains for Spanish economy and large composition of exporters mean Spanish small caps index is our preferred way playing an improving German domestic demand story.
MACRO/INDUSTRY STRATEGY
Bullish German Autos (Daimler) 15-Jul-2013 51.18 12.6% Expectation for strong H213 sales, ongoing cost reduction continuing to bearing fruit, and an attractive technical picture.
Bullish MSCI EMU Financials Index 24-Sep-2013 48.6 -0.2% EMU financials continue to trade at a deep discount to US counterparts despite improving eurozone growth prospects and reduced tail risks. Financial stability and ECB support has improved, and an acceleration in economic activity should support asset quality.

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This article is tagged to:
Sector: Country Risk
Geography: Europe, Czech Republic, United Kingdom, Hungary, Poland, Romania, Russia, Turkey, Ukraine
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