Back from the precipice.

May 26, 2011

FOREX, Global Macro

Finally some half decent news we can report on the Greek situation with Fitch Ratings releasing an outlook on German Banks overnight which is encouraging when Greece ultimately defaults, restructures or “prolongates”.

Fitch said that it does not envisage any ratings action on German banks as a direct result of their exposure to Greece. However it did note the risks associated with contagion that flows from a restructuring. Fitch said,

“The worst consequence of any Greek sovereign default for German and other European banks would be a sharp increase in general capital market and creditor risk aversion at a time when many banks are still in rehabilitation mode,”

We have little doubt that there will be contagion but what and how are unknown and unknowable because its hard to judge just how much leverage there is in the system which would get unwound following a default. And it’s not exactly going to be a surprise to anyone now is it? We could end up with GFC II but equally we could get something more short-term and ultimately benign. It’s difficult to tell and our suggestion is to plan for the worst and hope for the best. Certainly option’s cover on equity holdings, AUD longs and so forth.

In some ways though the Fitch release actually increases slightly the chance of a default because if German Banks aren’t going to be directly hurt by this then  one impediment to a default was just removed. Specifically Fitch said,

A hypothetical 50% haircut of Greek sovereign exposure would not result in such a depletion of banks’ capitalisation that a rating action would automatically be triggered, even for the more exposed banks. These either have strong owners, sufficient profitability or capital able to absorb potential losses without a structural impact on their business model, funding or franchise. The Long-Term Issuer Default Ratings (IDRs) of the more exposed banks will not fall below ‘A+’ (their Support Rating Floors) unless Fitch considers the ability and/or propensity of the German government or states to support them to have weakened.

So its good news for a change on the potential default impact.

Looking at the markets and the risk of contagion then we see that we have stepped back from the precipice we were at yesterday afternoon with the AUD getting hit along with equities in our region and on US futures night trade. This weakness was unwound while we slept and the tone is somewhat less pessimistic, although not ebullient, today.

However, we reckon that the market sure is at an interesting juncture at the moment as players grapple with the outlook for equities, bonds, commodities and currencies and what the potential impact of a Greek default might be in an already slowing growth environment and as summer holidays beckon.

Of itself some of the strength of the past nine months in global equities and commodities should be washing out anyway as economies slow, fiscal and monetary accommodation is withdrawn and consumer balance sheets are rebuilt. Look at the data from the UK last night for example where the outright numbers went backwards (-0.5%) but weren’t terrible (at least compared to market expectations) but the compositional break-up spoke of a 1 trick export orientated pony. That is net exports, the UK sold more stuff than it bought, along with Government spending were the key components from stopping growth fall further. We can leave aside Government spending as a driver because we know further austerity is kicking off soon, so its up to the Pound to help underpin what little growth there is in the UK.

Indeed net exports were a strong contributor because the pound against the USD and CNY has been relatively weak over the past year. While we can’t criticise the BOE for keeping the pound weak this is not a sustainable strategy for the globe as a whole because while everyone wants a weaker currency (it would really help Greece, Ireland and Portugal) they can’t all be weak at the same time. So the UK’s growth in net exports comes at a cost to another, or other, countries because Britain is both buying less internationally and selling more.

It’s also part of the unstated strategy of the Fed and US Treasury to keep US growth gurgling along and help American business. That is, weaken the USD substantially but not crash it.

The chart above is of the US Broad TWI from the St louis Fed. You can see the clear downtrend after the GFC flight to quality induced spike within a broader down trend. While many people focus on the more narrow “Major Currencies” index below I believe this is a better example of where the USD really is and gives some context to Treasury Secretary Geithner’s reiteration of the “strong dollar” policy. If you just look at the Majors then this claim has no credibility as you can see.

And for us here in Australia the cost is a stronger Aussie dollar and Australian industry and exporters under pressure as a result. All those internet overseas  purchases we make are just the reverse of what the UK and US are doing. We’re propping up sales in these jurisdictions at the detriment of Australian sales houses and retails shops even if we are selling plenty of our rocks and dirt to offshore.

All of which ties back to why the markets are at a strange juncture there are winners and losers out their but the overall macro situation seems tenuous. For the moment though, and after a look over the precipice yesterday afternoon markets are still holding in. At least for the moment.

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