London Update: Have the Europeans Ring-Fenced Greece?

The positive momentum in the markets is continuing today. Stocks are set to open higher in Europe and the euro is testing 2-month highs at 1.3260/70. What is more remarkable is that the surge higher in the euro at the London close yesterday was due to optimism that a deal had been reached between the Greek political parties agreeing on further spending cuts and austerity measures, however yesterday’s “deadline” was ultimately missed and EURUSD is still strong.

Caretaker PM Papademos met with the troika officials yesterday however the spending cuts could not be rubber stamped due to political wrangling with the leader of the main centre-right opposition refusing to accept measures that could make the economic situation for Greece worse. Papademos is set to meet the leaders of the three political parties who support the technocratic government later today instead. Although the markets seem oblivious to the outcome, a rubber stamp on new measures is necessary to ensure there is no problem with paying the EUR 14.5 bn bond redemption next month.

What is more worrying for the long-term stability of Greece, and thus the Eurozone, was the latest poll from Athens which showed a dramatic drop in support for the political parties that support Papademos and the technocrats. This makes the upcoming April election even more critical as it could give power to extreme parties, which may only make Greece’s problems worse.

But for investors, right now the bigger picture is that while Greece is in the throes of negotiations for its second bailout Italian and Spanish bond yields have continued to decline. Does that mean that the Europeans have ring-fenced Greece at last? We don’t want to speak too soon, but if we see a spike higher in Italian and Spanish yields then the macro situation will have changed – Greece may default/ leave the Eurozone – and while this remains a possibility we are not out of the woods yet.

However, the banks are in an undeniably better situation now than they were a few months ago. At its meeting tomorrow the ECB is likely to reinforce that its taps are on, even if some on the committee would rather it wasn’t quite so trigger happy with providing long-term cheap money to Europe’s banking sector.

The stabilization in the markets is being reflected in the “real economy”. The tie-up between Xstrata and Glencore suggests that the macro environment is now “stable” enough for gigantic mergers to take place in the commodity sphere. The $40bn merger may be coming in for some criticism from miffed Xstrata shareholders who believe the premium they are being paid is too paltry, but all the banks care about is 1, the juicy fees they will get from the deal and 2, the potential for other companies to start spending the vast amount of cash currently resting on their balance sheets. Things in Greece may be unsteady now, but the markets (and more importantly for banks and lawyers, the dealmakers) always look 6-months in the future and right now they see a place where the grass is greener.

This “optimism” is seeping into other asset markets: look at the Aussie, Italian and Spanish bond yields along with a weakening of the yen and dollar. Risk has been taking some breathers on its ascent, we have seen some pulling back in AUD/USD and AUD/JPY this morning, GBPUSD was sticky around 1.5900 and EUR/USD had a couple of attempts before breaking above 1.3270, however these were all just resting posts before attempts to move higher and momentum indicators at the moment suggest that 1.3300 is in the picture for EURUSD. Not even headlines that Germany was proposing delaying aid to Greece had much of an impact on the markets.

The bullish tone is down to central banks, of which we will hear more from tomorrow. The ECB is expected to confirm its commitment to LTRO, which is credited with kicking off the rally in risk markets at the end of last year. Investors will need to de-code the Bank of England at 1200GMT Thursday. If it increases QE - as we along with most of the market expects - then the important part will be whether it does GBP50bn or GBP75bn. If they do GBP50bn then it would suggest that they are less worried about the economy, which is pound positive. GBP75bn may worry some people as it would suggest that the Bank believes something sinister could be coming that not even the ECB’s LTRO loans can ameliorate, which could spook investors.

Yen longs are currently being unwound as the better environment for risk and the news of stealth intervention by the BOJ back in September erodes support for the safe haven. USDJPY is testing 77.00, above here opens the way to 77.50 then to 78.00. However, the link between Treasury yields and USDJPY is worth watching. The Fed is still committed to keeping rates low until 2014 and it hasn’t ruled out further QE, so this could keep a lid on how far Treasury yields will rise, and thus how much further USDJPY can go.

Ahead today, headline risk will take precedence especially from Athens as the economic data calendar is fairly light and investors wait for tomorrow’s ECB and BOE meetings.