Four Key Issues in the Week Ahead

Polls indicate that the outcome of the Greek referendum is too close to call. However, the results of the Scottish Referendum and the British national election are fresh our memories, and the polls there provided little guidance. While there is much uncertainty, there are a few things look clear.

Regardless of the outcome of the referendum, discussions of a third aid program will ensue. The main obstacle could be the domestic political environment in Greece, A "yes" vote would approve conditions for a program that has lapsed. The implication is more significant within Greece. It would likely lead to a collapse of the government that had campaigned against it. A unity government may be cobbled together ahead of snap elections, in which Syriza may still do well. .

A "no" vote is unlikely to produce a change in the official creditors' position. The Greek government and the official creditors were not as far apart as the rhetoric often suggested. Our sentimentality and love for drama often obscured the fact that the Greek government accepts 90% of the creditors' demands. There was one key issue, and that is debt relief. The IMF's report out last week made it clear that to put Greece's debt on sustainable path debt relief (from Europe) was essential. This may be a hint that without it, the IMF might not participate in a third assistance program.

The Greek banks are the Achilles Heel. The solvency of Greek banks was questionable even before the ECB's decision to freeze the ELA, and even more so now. The loan book could only have deteriorated as the economy is paralyzed. As part of the siege mentality that the Syriza government is endorsing aggravates the hoarding of cash. Comments from Greek banker warned that there is not enough cash to last more than a few days more. Recall too that as part of Greek banks core capital were deferred tax assets (tax credits for recording losses that can be used to offset future profits).

Even under the rules that prevailed before the referendum was called, Greek banks were running out of collateral that could be used to borrow from the ELA. It is possible and grows more likely with each passing day, that Greek banks need more funding than they have collateral to secure.

The ECB meets Monday, and regardless of the referendum results, it is difficult to see it deciding then to resume ELA authority. The tightening of ELA collateral rules, or the judgment that Greek banks insolvent, would likely increase the risk that nationalization/recapitalization will not only wipe out shareholders but also would likely lead to a bail-in of depositors, for which there were reports of such contingency plans. In 2013, the initial overture to take from all depositors was rebuffed and limited to those deposits in excess of 100k euros. Greece deposit insurance fund had roughly three bln euros at the end of May, or about 2% of deposit coverage.

II. China's Stock Market Support

Last weekend, the PBOC lowered its key one-year lending and deposit rates and cut reserve requirements. When this did not arrest the equity market's headlong plunge, officials hinted at reducing the stamp tax, easier margin rules and allowing pension funds to buy shares. Whatever upticks materialized were quickly sold into, and equity markets finished at new lows since the June 12. Since then the Shanghai Composite has fallen nearly 30%.

This weekend, Chinese officials seemed more desperate. They took several measures designed to stop equities from falling. New IPOs were suspended. This included 10 for the Shanghai and 18 from Shenzhen. Mutual fund companies (25) declared that they would "actively" buy stocks and hold them for at least a year. Chinese brokerage firms (21) pledged to invest 15% of their net assets (no less than CNY120 bln or ~$19.3 bln) to buy ETFs of high capitalization stocks as early as Monday.

China's sovereign wealth fund will also reportedly buy shares. Corporations are reportedly being encourage to buy back their own shares, as well. Regulators moved to market more difficult to short the futures index and are looking into claims of market manipulation by foreign investors. Officials indicated that there contrary to reports, there were no sizeable sales by foreign banks.

The pressures to steady a plunging stock market are clearly not limited to parliamentary democracies as some have argued. Moreover, not all stock market plunges are equal. Even with the dramatic drop, the Shanghai market is still up nearly 80% over the past twelve months, and the Shenzhen Composite is up almost 90%. Over this period, the economy has slowed, and industrial profits have fallen.

The Shanghai Composite has nearly retraced 12-month gains by almost 50%. That retracement would have brought the Composite to 3594. The low before the weekend was 3629. The 61.8% retracement comes in near 3220. Technical indicators do not suggest the signal an oversold market, though last week's close was just below the lower Bollinger Band, set 2 standard deviations from the 20-day moving average (~3723).

Chinese officials might have been better served to have waited for the market to signal that the selling momentum had exhausted itself, or that the market was extremely oversold before organizing such a price support operation. Margin use has been falling for nine consecutive sessions, and still stands near the equivalent of $208 bln. This should be wholly embraced not fought. Valuations by almost any definition remain stretched, even if less than a three weeks ago. Moreover, any near-term success may by Pyrrhic victory. Going forward, investors have to assume overhead supply. The Zhou put, like the Greenspan/Bernanke/Yellen put, creates a certain expectation among investors, which is not helpful in the long-run, and facilitates moral hazard.

III. US Growth and Fed Expectations

The US economy appear to have grown by a little more than 2% in Q2 after a small contraction in Q1. The June employment report was mixed. The flat earnings growth and decline in the participation rate were disappointing. The jobs growth and decline in the unemployment rate were more promising. Judging from the reaction in the Eurodollar and Fed funds futures, the market saw a slightly less risk of a Fed rate hike this year.

Given that there is now a Fed funds target range and Fed funds volatility at the end of the year, some variance needs to be incorporated into the calculus. For this exercise, grant the following assumptions: The Fed does not hike rates until the December 16. Fed funds average the middle of the Fed funds target. For the first 16 days, this is 13 bp the first half of the month average and 37 bp in the last 15 days. This would imply an average rate of about 24.5 bp. The December contract settled at 28 bp.

The US reports the service sector ISM and the May trade balance, which will inform Q2 GDP forecast, and more insight into the labor market (with the JOLTS and Fed's Labor Market Conditions Index). However, the market will likely be more sensitive to the FOMC minutes on Wednesday and Yellen's speech on the US economic outlook at the end of the week. The Chair's speech will likely touch on the key points she is expected to provide in her testimony the following week before Congress.

The FOMC minutes tend to be noisy as the policy signals are often muted by the cacophony of voices and debates. Nevertheless investors will look for color on the cuts in growth forecasts and the commitment to lifting rates, which a little more than half of Fed officials still saw two hikes this year as being appropriate at last month's meeting. Yellen's speech may be the clearest signal of the Fed's leadership assessment and intentions. The risk is that she is more hawkish than the market is currently discounting.

In the middle of the week, Alcoa reports its earnings to formally kick-off the earnings season. According to FactSet, Q2 earnings on a year-over-year basis are expected to fall by 4.5%. This would be the first decline since a 1% fall in Q3 12. FactSet estimates that the 12-month forward price-earnings ratio is about 16.5, which is above the 5-year and 10-year averages (13.8 and 14.1 respectively). In contrast to Chinese officials cheerleading equity investments, Yellen has cautioned that US equity valuations are elevated. Lastly, recall the impact from the dollar's rise in Q1 was less than many analysts had projected as it also cut input costs to US multinational production offshore. The dollar fell against the major currencies in Q2, except for the Japanese yen (-1.9%) and the New Zealand dollar (-9.4%).

IV. Policy Implications

The Reserve Bank of Australia meets next week. It is not expected to cut its record low (2.0%) cash rate, but it may more formally adopt an easing bias after the recent dovish comments by Governor Stevens. The RBA's statement and a soft labor report will likely boost expectations of a cut in August.

The Bank of England meets but this is a non-event. Although attention has been paid to a few hawks on the MPC, it is unlikely that anyone will vote for a hike now. Osborne's budget is likely to reflect the Tories' rule without the Lib-Dems. The borrowing target is likely to be cut, and more savings will likely be found from the welfare budget. A tighter fiscal impulse may weigh on sterling if it undermines speculation of the rate hike this year as some of the hawks have suggested.

Canadian data will be seen through the lens of the unexpected contraction in April GDP. A small increase in the volume of exports will not be sufficient to offset a soft June labor report (after a heady 58.9k increase in May) and softer building permits. Expectations for another rate cut is building though the next Bank of Canada meeting on July 15 might be too early.

The market will also likely watch Norway's data to confirm suspicions that the Norges Bank may cut rates again. However, the central bank does not meet until September. This reduces the likelihood that this week's release of May industrial production/manufacturing output or the CPI will have much impact, outside of the headline risks.

Germany, France, and Italy report industrial production figures. Even in the most subdued of times, the markets tend not to be particularly sensitive to this time series, and will be overshadowed by events in Greece. The ECB had indicated that it would front-load some of its bond purchases, due to the issuing schedule, but this does not appear to have materialized. This leaves many to suspecting that it was suggested to help stabilize the bond markets at the time when German yields were spiking from 4 bp and moving above 80 bp. There contagion spread to other European bond markets, and even US Treasuries.

China reports June CPI and lending figures. CPI is expected to have risen 1.3% year-over-year after the 1.2% increase in May. This will not be sufficient to neutralize concerns about deflationary forces. Non-food prices increases are less than 0.5%. This suggests there is still plenty of scope for the PBOC to cut rates if needed. The dollar was largely confined to about a 0.5% range the yuan in Q2 (CNY6.1880-CNY6.2210). The extremes were rarely touched. The 2% band around the fix that the yuan is allowed to move against the dollar is hardly explored. It is unreasonable to think that this narrow range was purely a function of market forces. If intervention is less obvious, it would appear officials have found another way to fix the currency.