Four Observations to Start the Week

The US dollar initially sold off on news that the New Democracy Party came in first place in the Greek elections, but has since recovered as the market recognizes that the euro area problems remain profound. Spain is still on the forefront and ahead of this week’s bill and bond auctions, the Spanish 10-year yield is up through 7%. Italian bond yields are also higher. The immediate positive reaction to the Greek news was seen in Asian equities where the MSCI Asia-Pacific Index advanced 1.3%. Of note, India’s shares declined amid disappointment that the central bank left rates steady (8%). 

There were widespread expectations for a 25 bp cut. The early gains in the Dow Jones Stoxx 600 were given back before a more stable tone emerged in late morning European turnover. However, Spain and Italian bourses are under-performing and financials are a drag. Greek bonds and Greek shares are broadly higher.

We make these four observations to start the new week. 

First, the Greek elections herald a new phase of negotiations with the Troika. Greece still faces a most arduous path. Troika officials will make compromises in the memorandum of understanding. Greece will be given more time, access to infrastructure funds and possibly lower rates on its aid. The Troika withheld about 1 bln euros in the latest tranche payment and this could be freed up. Last week’s announcement that Carrefour, the world’s second largest retailer, was selling its 50% stake in Greek supermarkets to a local partner is another form of capital flight. New Democracy is going to find tax collection and reform as difficult to deliver as the previous government. The Greek tragedy is not over and the intermission is unlikely to last long. 

Second, the fact that French President Hollande was able to secure a majority in the lower house (complimenting the majority in the Senate), puts him counter-intuitively in a better position to compromise with Merkel. He already seems to be backtracking on the euro bond push and instead is pressing for a 120 bln euro growth fund. It is to be drawn from 55 bln euros of unused EU structural funds, ramped up EIB loans and some project/infrastructure bonds). 

The G20 meeting that begins today and even the eurogroup and bilateral meetings later this week are part of the bureaucratic dance toward the EU summit at the end of the month. Although officials are playing down expectations, a plan being drafted by Barroso, Van Rompuy and Draghi that is to provide a road map to banking, fiscal and political union in the next decade. It may capture the imagination of many, but it will not address the current crisis and more immediate pressures.

Third, policy makers are on the move. China cut rates earlier this month. Her Majesty’s Treasury and the Bank of England announced new measures to boost lending and signaled the likelihood of a resumption of the gilt purchase. A rate cut from the ECB can also be delivered as early as next month. A couple ECB board members suggested that the deposit rate, which would likely be cut to zero, if the ECB cuts its main refi rate, no longer poses an obstacle. Previously this was thought to potentially create more problems in interbank lending. With inflation falling and the crisis deepening, the ECB appears poised to sacrifice more orthodoxy. 

Attention turns to the FOMC. The two-day meeting concludes Wednesday. The string of disappointing data since the May jobs data on June 1, coupled with downward revisions to back months, underscores the impression of an economy that once again has lost momentum in H1. The economy is still growing at a pace more than twice H1 11 and drop in gasoline prices and the decline in interest rates, alongside more signs of stabilization in the housing market, should see the economy re-accelerate in H2. However, given that the economy is under-performing Fed expectations and is not generating the 150k-200k jobs a month that Bernanke has indicated was necessary, some action is likely this week. 

We expect the need for insurance can be met through a version of Operation Twist that could include selling some slightly longer maturities at the short-end buying some MBS at the long-end. With the ECB apparently considering abolishing the rate it pays banks on deposits, perhaps the Fed should consider not paying interest on excess reserves (though there has been no talk about it).

Fourth, lost in the focus on Spain and Greece, Japan’s PM Noda moved a step closer toward the doubling of the retail sales tax. An agreement was struck with the opposition parties and a vote in parliament could take place as early as this week, though reports indicate Noda may seek to extend the current parliamentary session. It may split the DPJ Party as resurrected leader Ozawa’s faction is opposed. 

The last retail sales tax hike is still held by many as responsible for derailing the recovery in 1997. The retail sales tax increase is estimated to be worth about 2.8% of GDP, while the debt/GDP stands near 210%.