All Eyes On Greece Election, Will Greece Exit, Will Central Banks React?

The situation got a bit complicated just ahead of the crucial Greek elections. On the one hand, news flow from Europe were generally negative, with soaring peripheral yields and downgrades. On the other hand, risk markets were lifted by speculation of additional stimulus from central banks and coordinated actions by G20 leaders. It's reported that G-20 leaders, who will meet in Mexico on Monday and Tuesday, were already "preparing for coordinated action to provide liquidity" if global financial markets worsen markedly after the Greek election.

Indeed, BoE has taken the lead and announced credit-easing measures last week. ECB seemed to be opening doors for rate cut. While investors should be in deep worry of the Greece situation, the need for bailout for Spain and Italy, stocks jumped with Stoxx Europe 600 index rose nearly 1%and S&P 500 just had the first back-to-back weekly gain since April. The dollar did weaken with the Dollar Index back below 81 level. It's weird that investors were worried and were buying at the same time. And it even feels a bit like investors were hoping for the worst outcome from Greece so that central banks and officials would then have enough drive to do something drastic.

It's meaningless to speculate on the result of Greece election just a day ahead of it as the pro-bailout New Democracy and the anti-austerity Syriza are so close in this election. Let's just wait and see. But we'd like to point out that Greece staying in euro isn't euro positive as the problem will certainly drag on. And, Greece exiting won't do any help to euro either. The point is not on the euro, but who will gain most against euro. If Syriza wins, and the financial markets show drastic reactions on Monday, sterling will likely gain on safe haven flow while the aussie will likely regain strength after world leaders announce some strong measures to calm markets from panic.

If New Democracy wins and Greece stays, risk market could then have a pull back as world leaders would keep the bullets in the pockets first. Well, also, if it's as inconclusive as before, world leaders would also hold their hands first. In such cases, sterling and aussie could retreat against the euro first before developments in Spain and Italy send respective euro crosses lower again. Outlook of the dollar will remain mixed throughout as it's not the market driver for the moment. So it's a matter of selling EUR/GBP and EUR/AUD right after the election, or waiting a little while for recovery to sell.

To recap the situation in Europe, Spanish Finance Minister Luis de Guindos announced that the country would request financial assistance from the EU for recapitalization of the Spanish banking system. While the final amount would be released after the results of 2 independent audits due June 21, the sum is estimated to be 100B euro, covering estimated capital requirements and additional safety margin.

The announcement didn't restore any confidence from markets as Spanish bond yields breached the 7% level and made a euro-era record. Moody's downgraded credit rating of Spain by three notches to BAA3 from A3 as the bailout fund would raise the country's debt burden and it would rather be a "sign of weakness" instead of " a sign of strength." Last week, another rating agency, Fitch slashed Spain's sovereign credit rating by three notches to BBB. Fitch rating managing director Ed Parker even warned that Spain could miss the deficit by a "substantial margin" next year. Also, Parker said that if they see "further worsening or more general intensification of the eurozone crisis, then further negative news could lead to further negative rating action."

Moody's also downgraded the credit rating of Cyprus to BA3 from BA1 and is on review for further downgrade. It noted that it's banking sector is heavily exposed to Greece. Cyprus Finance Minister Vassos Shiarly said that recapitalization of banks in the country is "urgent" and time is pressing and hinted that it may seek a bailout. If Cyprus chooses to seek bailout from EU, a total of around EUR 3-4b would be asked for. And the request could be a "comprehensive" package covering "present circumstances," "recapitalization of banks" and "future needs."

A US independent rating agency, Egan-Jones warned that Spain and Italy could need a full-scale bailout within six months. Founding Partner and President Sean Egan said that "it makes little sense to separate the banks' credit quality from the governments' credit quality." He predicted that Spain will be "back at the table" and ask for more than the EUR 100b they sought. Meanwhile, Egan also noted that the combined economies in EU have fairly high debt-to-GDP, and the assumption that Germany will be able to pull may need to be "re-examined."

ECB president Draghi said that providing liquidity is what the bank has done "throughout the crisis, faithful to our mandate of maintaining price stability over the medium-term" and he pledged to continue to "supply liquidity to solvent banks where needed." Meanwhile, Draghi also noted "serious downside risks" in eurozone with "heightened uncertainty." Meanwhile, Draghi said inflation expectations were well anchored and there is "no inflation risk" in any eurozone country. Overall the comments indicates that Draghi is starting to pave way for rate cut and additional liquidity support. And it's been speculated that if Greece situation worsen, ECB could cut by more than 25bps in July and could probably add another round of LTRO.

In its bi-annual Financial Stability Review, ECB urged that it's now necessary to go beyond monetary union and conceive a "banking union" as an integral part. Three important objectives were identified including banking sector supervision, a European deposit guarantee scheme and contribution of financial industrial towards stability. ECB emphasized the need to tackle the "root causes" of the debt crisis and urged comprehensive response from officials to end "a spiral of systemic risk augmentations." Nonetheless, ECB also noted key risks to financial stability including aggregation of debt crisis, lower bank profitability on weak economy and excessive pace of deleveraging.

In US, economic data released in recent weeks raised the chances of additional easing from the central bank. The US economic indicators released were disappointing. Initial jobless claims surprisingly rose +6K to 386K in the week ended June 9. Inflation moderated further with the May CPI rising +1.7%, following a +2.3% gain a month ago. The core reading stayed unchanged at +2.3% during the month. Industrial production unexpectedly contracted -0.1% in May following a +1.1% gain in the prior month. The Empire State Manufacturing index shrank markedly to 2.3 in June from 17.1 in May. This sent a signal that the ISM manufacturing index for this month would worsen.

Moreover, the University of Michigan index showed that confidence fell to 74.1 in June from 79.3 in May. The upcoming FOMC meeting would catch a lot of attention as policymakers may decide whether to adopt more unconventional stimulus to bolster the economic growth. Yet, it is unlikely for the Fed to act this month. Besides the situation that recent deterioration in US data has not reached a level that triggers an immediate move, policymakers would prefer to wait after the Greek election and expiry of operation twist.

In the UK, the Treasury and the central bank step up measures in an attempt to loosen the credit and financial markets. Over the next few weeks, the government would launch a scheme to stimulate bank lending by offering to loan banks funds at below market rates for a period of perhaps 3 to 4 years. The BOE will also activate the Extended Collateral Term Repo facility which provides 6-month liquidity against a wide range of collateral. Moreover, Governor Mervyn King stated that "the other effect of the euro area crisis has been to create a large black cloud of uncertainty hanging over not only the euro area but our economy too, and indeed the world economy as a whole... With signs of a deterioration in the outlook, especially in world markets, the case for a further monetary easing is growing." This signaled further asset purchases would probably be announced at the upcoming BOE meetings.

BoJ left rates unchanged 0-0.1% on unanimous vote today as widely expected. Size of the asset purchase program was also maintained at JPY 70T. The central bank noted "some nervousness" in the global financial markets due to European debt crisis. And it pledged to "do its utmost to ensure the stability of Japan's financial system." Domestically, it said that the economy "has started picking up moderately as domestic demand remains firm, mainly supported by reconstruction-related demand." Assessment of exports and productions was also upgraded and are seen as key factors to assess the local economy.

The SNB announced to leave the target range for the three-month Libor unchanged at 0.00-0.25%. The central bank also reiterated to "maintain the minimum exchange rate of CHF 1.20 per euro and will enforce it with the utmost determinatio." Policy makers viewed that Switzerland's economy remain "exceptionally high" and warned that current level of Swiss franc remained too high. The SNB pledged to take any measures to defend the EUR/CHF floor.

The RBNZ left the OCR unchanged at 2.5% in June although it noted that New Zealand's economy has weakened a little since the March MPS. The central bank has postponed its first rate hike from late this year to next but the overall interest rate track is just slightly lower. GDP growth forecasts were lowered this year and as an average over the coming 3 years. Concerning future monetary policy outlook, we believe the RBNZ would keep the door open for further easing if the macroeconomic situation deteriorates further.