As if to emphasise just how terminal the situation in Europe is, the euro-phoria following the weekend Greek election outcome lasted barely a few hours. Quite quickly, the realists concluded that a stable Greek government was extremely unlikely and that even if one did emerge, its ability to implement any troika program would remain equally problematic. In Spain, talk that the funds needed to recapitalise the banks could be as high as EUR 150bn contributed to another savage sell-off in bonds, with the Spanish 10yr yield soaring to 7.25%, well above the 7% level that supposedly triggered full-scale bailouts for Greece, Ireland and Portugal.
It was hardly any less frightening in Italy, with the 10yr yield reaching 6.2%. The euro fell back over the course of the day to below 1.26 at one stage. The fact that honeymoons are now measured in hours rather than the days or weeks seen previously should be a strong message to G20 leaders meeting this week. Markets still fear that a Lehman moment is still yet to come and so long as European leaders stick with their piecemeal, eleventh hour approach, they are right to be fearful.
Commentary
A red flag for dollar bulls.For the dollar, the background environment of the first half of this year has been fruitful. Europe’s financial flagellation has contributed to a surge in safe-haven demand and risk aversion, with the dollar a beneficiary. Also, in contrast to most other advanced economies, the US recovery has looked relatively secure, certainly a lot better than in Europe. Sovereign wealth funds have been buyers of dollars, their conviction in the safety of the euro diminishing. And yet, it could be contended that the dollar’s performance has actually been rather indifferent. Indeed, it is actually quite surprising that it has not done a lot better. For instance, the Dollar Index is up less than 2% for the year to date, although to put this into context it is worth recalling that the dollar recorded a rise of 8% in the second half of 2011.
Traders and short-term speculators are incredibly bullish on the greenback – according to the CFTC, cumulative long positions in the dollar (against the euro, yen, aussie, CAD, kiwi, swissie and Mexican peso) were last week above 300K for the second week running, a record. In addition, the US recovery is looking more vulnerable these days. Fed officials are especially mindful of the impact of the "fiscal cliff" pencilled in for the end of this year, which could drag the economy back in to recession if implemented in full. Ahead of this week’s FOMC meeting, some policy-makers on the Board have intimated a willingness to ease the stance of monetary policy further. This may take the form of an expanded Operation Twist (the current program is worth USD 400bn) and possibly an extension to their guidance on short-term rates.
If the economy does lose some further traction and/or the Fed opts for aggressive easing measures, then the dollar may well fall out of favour. There is also the question of the outcome of the Presidential election in early November, and the likelihood that the US government will hit its debt limit-ceiling of USD 16.2trln late this year. Last summer, the dollar dropped sharply amidst an acrimonious debate in Washington over the issue. A repeat of this political brinkmanship would surely weigh on the US currency. Dollar bulls need to be alert, notwithstanding the ongoing car-crash that is Europe.
A busy time for global policy-makers. Prior to their summer vacations, global policy officials have an extremely full agenda as they attempt to stabilise Europe’s banking and sovereign debt crisis. In Greece, New Democracy Leader Samaras will continue negotiations with Pasok leader, Venizelos, to establish a new coalition government. Time is of the essence – Greece has been without a functioning government for more than two months and the Troika will want to see that any new government is committed to the terms of the previous bailout before sending inspectors back to Athens. According a senior official in the Greek Finance Ministry, his country will run out of cash within four weeks unless the Troika agree to release the next quarterly instalment of bailout money.
Over in Los Cabos, Mexico, G20 officials will also be focusing very closely on the deteriorating situation in Europe. Work on a joint communiqué over the weekend was focussed on exactly how to convey a dual message of austerity and growth. Over the next two days the FOMC meet to consider whether an additional round of quantitative easing is required. The pace of recovery in the US has moderated over the past couple of months, due in part to the worsening situation in both Europe and China. In addition, senior Fed officials are very concerned that the economy will be affected negatively by the strict regime of tax hikes and spending cuts to be introduced automatically at the end of this year. Fed policy-makers may opt to extend Operation Twist, a USD 400bn program under which the US central bank sells shorter-dated debt securities and purchases longer-dated ones.
Euro-area finance ministers meet on Thursday and Friday when proposals such as joint eurobonds, a banking union and growth-focused policies will be put in front of Germany to consider once again. German Chancellor Merkel meets leaders from opposition parties on Thursday in an attempt to secure their support for the fiscal pact prior to a vote in the Bundestag on June 29th. The latest EU Summit is due to be held on June 28th and 29th. A proposal for deeper euro-integration will be presented by ECB President Mario Draghi, EC President Barroso, EU President Van Rompuy and President of the Eurogroup, Juncker. No doubt Germany again will have reservations.
India’s growing troubles. Overshadowed by the Greek election news was the lack of a rate cut yesterday from the Reserve Bank of India, which came as a surprise to markets. Most were expecting at least a 25bp cut in the main refinancing rate (from the current 8.00%), with some gunning for 50bp. Similar to its BRIC peers India is facing slower growth but it appears that the inflation picture stood in the way of an easing. This sits in contrast to the easing seen in recent weeks both from Brazil (continuing the easing cycle started last year) and China. But compared to Brazil, the currency is a bigger factor for the Indian authorities.
Over the past month the rupee has been one of the weakest performers on the emerging market currency board with just the Russian ruble performing worse over this period. India, however, has to worry more about the currency given that imports as a ratio to GDP (around 28%) are twice that of Brazil. As such, the recent weakening of the currency poses a greater threat to the inflationary outlook. Of interest though is that the currency weakened on the announcement of rates being kept on hold, so if the authorities were looking to stem the recent weakness, their efforts look to have been unsuccessful at first glance. The reaction appears to be more linked to the diminished level of confidence among investors in the ability of the authorities to deal with the slowdown in the economy. In the wider picture this is not welcome news because, in contrast to 2008-2010, the ability of the large emerging nations to counteract the weakness being seen elsewhere is looking seriously diminished.
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