June 18th 2012: Weekly preview - Men in black will keep Euro decline orderly
Even if Greece can scrape together a coalition government following the latest election, the mood remains bleak and the result will not provide a backdrop for medium-term stability. Without a major policy shift in the Euro area as a whole, net outflows of capital will weaken the Euro, especially as global confidence in the region has been severely damaged. With global central banks remaining on high alert and prepared to act quickly to add the oxygen of liquidity to prevent market dislocations, an ultra-bearish stance on the Euro and risk assets remains dangerous with selling into rallies still the best strategy.
Although the Greek election result has not yet been announced officially, New Democracy is on track for a narrow victory with no majority. Greece remains in trauma and there will be little in the way of celebration as the divisions and despair are also an illustration of a wider no confidence in current Euro-zone policies. There will be massive international pressure for Greece to form a cohesive government, especially given the destabilising impact on the rest of the Euro-zone. Whatever the composition of the administration, there is no doubt that it will also be looking to change the bailout terms, but it will have a weak hand to play.
There is a high risk that any coalition will be so weak as to be unable to govern or negotiate effectively. The German stance will inevitably also be critical over the next few days and it seems very likely that patience will be exhausted very quickly even if minor concessions are forthcoming.
The possibility of a smaller, hard Euro-zone area being formed remains a key factor preventing Euro bearishness running at full throttle and this remains a crucial factor in keeping the Euro afloat. Without this scenario, the Euro would already be trading near parity with the US dollar. The net risks still point to a weaker Euro given the steady drain of capital outflows and selling into rallies remains the best option, especially as pressure on the ECB will be intense.
The Greek drama will be compelling, although developments elsewhere are likely to be equally critical if not more so for the Euro-zone as a whole. In economic terms, developments in Spain and Italy will be vital for the underlying Euro outlook. Benchmark bond yields rose sharply last week with Spanish 10-year yields touching 7.0% and yield trends this week will have a critical impact. Domestic political developments will also need to be watched very closely, especially with evidence of increasing policy fatigue and resentment. There is a high risk that resistance to current economic policies will intensify within Greece, Spain and Italy.
There is simply no way that the current policy mix can be sustained. It is not possible to predict the precise point at which the Euro-zone will implode on its current trajectory, but the laws of economics cannot be denied and without growth the current path remains completely unsustainable. Regardless of the political backdrop, pressure on the ECB is likely to increase on economic grounds. There is an urgent need for reflationary policies throughout the peripheral economies. This can be achieved by enacting radically pro-growth policies throughout the Euro area in which case the German economy will have to accept higher inflation. Alternatively, the peripheral economies will need to boost external competitiveness by leaving the Euro. Until this decision is made, there will be no end to the crisis.
The Mexico G20 meetings on Monday and Tuesday will inevitably be a key focus, especially in view of their timing immediately after Greece’s election, with central banks and governments considering their options and standing by to inject liquidity. If immediate market panic is avoided, leaders will need to focus on a medium-term change in strategy.
The Federal Reserve FOMC decision on Wednesday will inevitably be a very important focus, especially with fresh concerns in capital markets. Domestically, there has been a generally weaker data stream over the past few weeks with downbeat employment and retail sales reports. There is little doubt that the Fed will adopt a broadly dovish stance at the latest meeting. It is also certain that there will be calls from some members for the Fed to take additional action to support the economy. The overall evidence suggests that there will be a reluctance to sanction additional quantitative easing, not least because there are growing doubts whether further action will be effective in supporting the economy and benchmark bond yields are already at historic lows. The most likely outcome is for an extension of operation Twist. The latest economic projections and Chairman Bernanke’s tone in his press conference will be very important for market sentiment.
There are very important economic data releases throughout the week and these will have an important impact on underlying direction and global economic pulse even if the immediate impact is drowned out by political noise. The data will certainly be vital in determining how quickly the Euro-zone runs out of options.
The Euro-zone flash PMI indices are due for release on Thursday. In particular, there will an important focus on the German industrial data following a series of weak readings. If there is a weaker than expected PMI index, there will be further pessimism surrounding the near-term outlook which increase pressure both on governments and the ECB. The German ZEW index will also be released on Tuesday and a slide back into negative territory would reinforce fears that the German locomotive is faltering. The IFO release is set for release on Friday with the index dipping significantly for may after months of resilience. This a key benchmark indicator for the actual German economic outlook and a further slide would reinforce fear as well as substantially increasing pressure for economic action.
A notable feature of the past few weeks has also been additional strain on the BRIC countries with particular doubts surrounding India and China. There has also been an important feedback loop with additional demand for the US currency as emerging-market doubts have increased. In this context, China’s HSBC flash PMI index will be watched very closely on Thursday and any further deterioration would undermine confidence.
As far as the UK is concerned, the latest Bank of England minutes will be important for Sterling, although the minutes will inevitably be over-shadowed by events. The balance of opinion within the MPC will be watched very closely as markets assess the potential for further action at the July meeting.
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