Thursday Promises to be Important

Currency in Crisis

There are three key events on Thursday and each has potential to impact the global capital markets.  

First the Bank of England meets.  It is most likely going to announce plans to extend its gilt purchase program.  It will indicate that is has bought about GBP275 bln worth of gilts and will signal intentions on buying at least another GBP50 bln and perhaps as much as GBP75 bln.  

There is some debate over whether there is a limit to the amount of gilts that the BOE can buy.  As of  the end of last year, there were almost GBP800 bln of conventional gilts outstanding and roughly another GBP200 bln of inflation-linked instruments.  

It is unclear how much of the stock of gilts the BOE feels comfortable owning.  Surely it would not feel comfortable owning the entire stock.  Already it owns about 34% of the outstanding conventional gilts and about 27.5% of the total gilts, including the inflation-linked component.  

The line might as the US Supreme Court Justice Potter Stewart once famously said of pornography--that it is difficult to define but  he knows it when he sees it).  Perhaps another way to think about the potential limits is to put the BOE's purchases in the context of net new supply.  Unlike the Federal Reserve, which appears content to buy more than the net new issuance of a particular instrument, the BOE seems to be content to essentially absorb most of the new net issuance.  

Second, the European Central Bank meets.  At the end of last year, a rate cut in February seemed likely.  However, with some signs, primarily the PMI headline (not so much with some of the forward looking components) appear to have stabilized for the moment, the pressure on the ECB to ease monetary policy has eased.  The next rate cut is more important than the two Draghi, who is celebrating is first 100 days in office (and how dramatic have they been) delivered already.  These were simply unwinding the (ill-advised, we argued at the time) hikes Trichet oversaw. 

The next cut would involve bringing the repo rate to 75 bp and, assuming the ECB keeps the policy corridor unchanged (+/- 75 bp), the deposit rate would be cut to zero.  I have advocated that given the large amount of deposits banks give to the ECB overnight, officials consider not paying anything. The ECB could narrow the corridor say to +/- 50 bp, but a narrower corridor is associated with tightening of monetary conditions.  This is not the signal the ECB wants to send.  

Draghi's press conference is important.  The market is trying to get accustomed to the new central bank head.  It is not yet familiar with his style or word cues.  Draghi may say something about the new widening of the acceptable collateral, which will include asset backed securities.  

He will likely be asked about ECB participation in the Greek aid.  Draghi is unlikely to share new insight here as it would be premature, given the still lack of agreement with the Troika and the private sector involvement (PSI). 

Third, the European finance ministers have called a meeting and the head of the IMF will participate as well. This is a signal that an agreement is now at hand.  The meeting would not have been called otherwise.  

With the long-term repo easing the extreme tail risks, it weakened Greece's negotiating position.  It appears Greece has capitulated on the key issue of deeper cuts in minimum wage and additional reduction of civil service workers.  

The PSI details will also be forthcoming.  The IIF also appears to have capitulated after it had said that 4% coupon for the new bonds was its last best offer.  Reports now suggest 3.5% coupon.  The 30 bln euros from the second Greek aid package that was to be an inducement to participate may be in the form of new EFSF bonds.  The issue of the extent of the participation in the PSI is unresolved, but its likely to be clearer shortly.  Note too that the bond maturing March 20 may be including in the PSI.  

This does not mean the European crisis is over.  It is simply entering a new phase.  It may be a touch cynical to suggest, but the risk is that the Greece problem is not yet really resolved and may very well re-emerge to shake the markets.  Not only is 120% debt to GDP (in 2020) not sustainable, but even more immediately, reports suggest that Greece's tax revenue from the VAT plummeted by almost 19% in January.  

This is most certainly not tax evasion, but a sign of imploding demand.  An estimated 60,000 Greek small businesses and family owned businesses have failed in the past six months. Overall tax receipts are off 7% year-over-year.  This is also more likely a consequence of the economic collapse than tax evasion.  

Don't forget that the Greek parliament still will have to approve any agreement and with an election looming, it is not clear that the MPs, who are seeing support erode, will accept Troika approval in exchange for antagonizing their constituents.