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    IronFX Daily Commentary | 08/07/15

    08.07.2015, 9am

    China hurts as well as Greece I’ve been focused on the Greek drama and only yesterday wrote about what’s going on in China. But if you look at the financial world, it seems that the troubles in China are having more of a global impact than the Greek issues. It’s true that virtually all European stock markets were down yesterday, while US stocks were higher – indicating particular pressure on Europe. But there was also a total rout in the commodities market – oil, every metal and most of the soft commodities were lower (orange juice and hogs being the main exceptions – breakfast for some is a little bit more expensive). Meanwhile the commodity currencies are doing the worst among the G10 over the last week, with AUD and NOK down 3.3% in just five days. That’s probably the influence of China. This morning too, all the major Asian stock markets are down, led by Chinese stocks.

    SEK falling too Nestled among the list of losing currencies is one outlier: SEK. It comes right in the middle of what is otherwise a list of commodity currencies. Why would SEK be so weak? My guess is two-fold. On the one hand, the surprise loosening at last week’s Riksbank meeting is still reverberating in the market. Secondly, there is the underlying reason why the Riksbank eased at the last meeting, which is Sweden’s dependency on Europe. About half the country’s exports go to the Eurozone (62% to the EU as a whole) and so it is very much exposed to a weak European economy and weak euro. But does Eurozone weakness explain why SEK should be weaker than the euro itself? Apparently yes. Looking at the correlation between the currencies and the Eurostoxx 50 over the last 10 years, EUR/USD has a correlation of 0.23 while USD/SEK is -0.40 – almost twice as high. EUR/SEK is also higher than EUR/USD at -0.35. SEK also has a higher correlation with oil than EUR does, indicating closer reliance on global growth. With a current account surplus of 6.8% of GDP last year (vs 2.1% for the Eurozone) Sweden is more dependent on foreign trade. In short, while it is not a commodity currency it is highly exposed to the global economy in general and the European economy in particular and thus may be particularly vulnerable when problems in Greece and China threaten simultaneously.

    • Meanwhile, the dollar was higher almost across the board even though US interest rates continued to decline and Fed funds rate expectations retreated further. The only exceptions were JPY, which benefitted even more than the dollar from the flight to safety, and RUB – perhaps because of the late bounce in oil?

    Why is the Chinese market crashing? Yesterday someone asked in our morning meeting why the Chinese market is crashing. To me, that’s not the right question. The right question – one to which I have no good answer – is, why was it rising to begin with? Check out the graph to the left, which shows the movement of the market vs the expected earnings of the companies listed on the market. Then look at the graph on the right, which shows the number of new accounts being opened – a series that peaked at 4.2mn in one week in May! As Sir Isaac Newton (who also lost a fortune in the stock market) said, “I can calculate the motion of heavenly bodies, but not the madness of people.”

    Greece gets Sunday deadline It’s rather amazing that the new Greek finance minister failed to present any new proposals at yesterday’s meetings. His counterparts apparently got fed up and set a deadline of Thursday (evening, apparently) to make a new proposal including detailed reform plans. The other EU leaders (including the non-Eurozone members) will then consider it on Sunday. That’s it. “Tonight I have to say loud and clear -- the final deadline ends this week,” said EU President Tusk. “Inability to find an agreement may lead to bankruptcy of Greece and insolvency of its banking system.” What I take this to mean is that if they don’t reach an agreement by Sunday night, the ECB will cut off aid to the Greek banking system, leading to its insolvency and the introduction of a new currency in Greece. EC President Juncker was clear: “we have a Grexit scenario prepared in detail” if they fail to reach a deal.

    • This means Greece has to accept the previous EU proposal and probably go a little further to compensate for the deterioration in the economy since then, or else the rest of the group will eject Greece. However, an acceptable compromise still looks difficult. German Chancellor Merkel is still insisting that a debt write-off is out of the question, while a debt write-off remains the Greek’s main goal.

    • A Greek government official said the country would present Wednesday the “common ground” for a viable agreement with its creditors, taking into account the result of the referendum, Greek political leaders’ positions and the creditors’ proposals. The government’s proposal is for an “arrangement” until the end of the month in order to prepare a bigger, viable agreement. The official said that the Eurogroup would hold a conference call Wednesday to review the “common ground.” I wonder though whether the rest of the group will really be interested in another short-term fix while the endless negotiations drag on further.

    Would a Greek default be harmless? Not quite! The market is assuming that a Greek default and exit from the Eurozone would be relatively harmless. The international banking system has almost negligible exposure to Greece: most of Greece’s liabilities have been transferred to the public sector, while banks are much better capitalized than they were when the crisis began in 2009. Hence the risk of a systemic banking crisis has almost disappeared. But that doesn’t mean there are no costs – it only means the costs are distributed differently than before. Barclays Bank had a useful table giving the costs for each country of a Greek default (see below). It comes out to 3.4% of Eurozone GDP – a substantial figure, but probably manageable for most countries (although certainly not helpful for European growth prospects).

    • Barclays also highlights several things that could go wrong with the Grexit, including:

    - The backstops are not entirely infallible The new banking union, with its EUR 55bn resolution fund, is still 95% unfunded and there is still no pan-European deposit insurance. The ECB’s “Outright Monetary Transactions” program, meant to defend countries that are struggling to issue bonds, comes with significant conditionality and in any event has never been tested.

    - It establishes a new precedent Greece would establish a new precedent that a country can leave the Eurozone. Would investors extend that possibility to other countries in financial difficulty, such as Portugal and Spain? What about France, whose cumulative deficit is similar to what Greece’s was several years ago?

    - The political risks remain unknown The Greek default of 2012 was sold as a one-off event. If it’s followed several years later by another, bigger default, then not only the right-wing parties that have always objected to bail-outs but also even the more moderate parties may question the bail-out mechanisms. The smaller countries too, such as the Baltics, would be asked to bear a larger burden of Greece’s default, relative to their GDP, than Germany or the other wealthy core countries. This might give rise to a considerable backlash against further support for peripheral economies, not to mention the increased mutualization of risk that is essential for the monetary union to develop into fiscal union as well.

    Thomas Piketty on Germany and debt: Economics Prof. Thomas Piketty, author of the best-selling Capital in the Twenty First Century, said, “When I hear the Germans say that they maintain a very moral stance about debt and strongly believe that debts must be repaid, then I think: what a huge joke! Germany is the country that has never repaid its debts. It has no standing to lecture other nations. ... Germany is really the single best example of a country that, throughout its history, has never repaid its external debt. Neither after the First nor the Second World War. However, it has frequently made other nations pay up, such as after the Franco-Prussian War of 1870, when it demanded massive reparations from France and indeed received them. The French state suffered for decades under this debt. The history of public debt is full of irony. It rarely follows our ideas of order and justice.”

    • Today’s highlights: Wednesday is rather light on data. There are no major indicators on the agenda during the European day.

    • In the UK, Chancellor of the Exchequer George Osborne announces a revised budget following the Conservative Party’s victory in the May election. His previous budget, announced in March, was constrained by having to govern in conjunction with the Liberal Democratic Party. Today’s budget will set out the Tories’ plans for taxes and spending for the rest of this Parliament.

    • The highlight of the day will be the minutes of the June FOMC meeting. At this meeting, the most important outcome was the distribution of the “dot plot”. Fed officials lowered their interest rate forecasts, which turned out to be more dovish than expected and were fairly split between one and two hikes this year. This was less clear than the previous FOMC forecast, when the Committee was projecting two rate hikes this year. Fed members also lowered their economic growth projections while raising their forecast for the year-end unemployment rate. We believe that despite the lowered interest rates forecasts and the downward revision of the economic outlook, September remains the most likely lift-off month, assuming that the US economic outlook continues to improve. However the probability has declined somewhat as the Fed is aware of its international responsibilities and is likely to take Greece’s debt crisis into account when formulating its plans.


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