What Brinkmanship Means

The June 14 meeting of European finance ministers did not resolve the dispute that is splitting the euro zone. This outcome is hardly surprising.  The logic of brinkmanship tactics say it is too early to blink and in this environment, the euro looks particularly vulnerable.

One one side is of the game is Germany, Austria, Finland and the Netherlands.  They seem to be pushing for bond holders to share in the adjustment process and appear to agree with the German proposal of having bond holders roll out their holdings of Greek sovereign bonds for seven years.

The ECB, France, Belgium and Spain are concerned that the German proposal would lead to a credit event and are playing a game of brinkmanship of their own.    Last week, Trichet did not have to say that the ECB would not roll-over its Greek debt.  It appears to be among the largest single owners of Greek sovereign bonds.  It has said it would hold those bonds it purchased until maturity.  He could have said, it up to the board and no concrete proposal has been received.  But his off the cuff refusal sent a powerful message to Greece's other creditors.  

The rating agencies have already indicated that given Greece's ratings and condition, an exchange would be considered distressed and be regarded as a default.  It is ultimately ISDA's decision whether it triggers the credit default swaps.  However, it would be difficult for the rating agencies to claim a default, selective or otherwise, and for ISDA to disagree.  

And whatever happens to Greece, investors will conclude, is the future of Ireland and Portugal, though officials in those countries deny that, of course. 

As the finance ministers met, Greece reported its budget deficit grew in the first five months of the year. This underscores the challenge Greece is having implementing the IMF/EU strategy.  Greek 10-year bond yields rose to 17.45% following S&P 3 step downgrade to CCC (with a negative outlook).  

Brinkmanship tactics require pushing toward the abyss only to pullback at the last moment.  Think Cuban Missile Crisis.  The June 14 fin min meeting was never the forum for resolution of the brinkmanship game. There is still plenty of time left, which means there is no need to blink quite yet.  What is next? 

On June 17th Merkel and Sarkozy meet in Berlin.  France and Germany.  That was the pillar of the euro zone.  But Germany appears to increasingly going its own way.  It changes to it constitution not only enshrine a balance budget but it freezes German contribution to the EU.  Merkel's reversal on nuclear energy further pushes it away from the EU.  In the aftermath of the Japanese nuclear disaster, other countries, such as Italy are having second thoughts about nuclear power, though not France (so far).  This further pushes Germany into a closer relationship with Russia, which it may become increasingly dependent on as a source of energy.  

In any event, Merkel and Sarkozy are unlikely to reach an agreement.  The finance ministers will meet against on June 19-20.  Here too the market will be disappointed with the lack of agreement.  Until now, there seemed to be a reasonable good chance that at the heads of state summit on June 24 would produce an eleventh hour agreement.  However, Greece does not need the money until some time in July.  There has been some speculation in the market that it may need the money--that is the next tranche of IMF/EU money--before then, though that is not immediately clear.    

Therefore the risk is that the June 24th summit is not sufficiently close to the brink to force an agreement.  An agreement still seems to be the most likely scenario chiefly because the other alternatives look worse.  As Trichet noted on June 9th, officials, and by that he likely meant the bloc led by Germany, "are flirting with what could be an enormous mistake."  

The 5 and 20 day moving averages often provide a useful guide to the near-term trend.  Sterling often leads the euro and its 5-day moving average is already toying with its 20-day average, signaling an erosion of the near-term trend.  The euro's moving averages have not crossed but they can later this week or early next week.  

The $1.4500 area now likely denotes the upper end of the range.  Initially support is seen in the $1.4285-$1.4300 area.  A convincing break of $1.4250 likely will be seen as a signal to retest $1.40.    That said, the euro still seems fairly resilient in the face of the credit risks around the corner and the continued pressure on the periphery and some widening of spreads in Spain, as if the firewall is coming under pressure, albeit still quite modest.   The resiliency could be a sign that the market has taken on board most of the bad news and is looking past it.  Alternatively the resilience could be a temporal issue and the euro under this possibility is quite vulnerable.   My read of the technical and fundamental entrails favor the latter.