Thoughts on the Greek Referendum

While I have consistently been highlighting the political risks in Greece that could throw a new monkey wrench into European plans and global capital markets, today's turn took me by surprise. The euro had been trading heavily all day and Italian bond yields were holding above 6%, despite talk of ECB purchases, and the French-bund spread was widening. News that the Greek government was going to hold a referendum on the European agreement accelerated risk-off moves and the euro retraced in full the impressive gains scored last Thursday in response to the broad outline of the European plans, the third comprehensive, final deal put forward this year.

German 55.5 bln euro Error to be Explored

It appears that an accounting error at FMS Wertmanagement, the bad bank for Hypo Real Estate, may have overstated the debt by 55.5 bln euros (~$77.7 bln). FMS. FMS has reportedly corrected its figures, to lower the debt by 24.5 bln in 2010 and by 31 bln euros for this year. The accounting adjustment will reduce Germany's debt/GDP by a couple of percentage points (to 81.1% from 83.7%), but before coming up with new ways to spend the money, such as increase the contribution to EFSF or other international aid packages, recall what we are discussing here is a smaller loss.

The borrowing figure for FMS stands at a whopping 161 bln euros. The source of the error appears to be derived from the fact that the collateral for derivatives was not netted between the asset and liability side. Rather than subtract funds apparently they should have added. FMS will account for 161 bln euros of Germany's debt down from 216.5 bln euros last year.

BOJ Shows Hand and Other Developments

The Bank of Japan intervened unilaterally in the foreign exchange market for the first time in three months and sent the dollar from JPY75.35, record lows, to JPY79.50 in two hours. Estimates put the size of the intervention at a new single day record near JPY6 trillion. The IMM Commitment of Traders showed the next speculative position had more than doubled in the most recent reporting period to 54.3k contracts from 26.9k contracts previously.

Although the intervention produced instant gratification for Japanese officials, the market began fading it quickly. Japanese officials quickly indicated they were not seeking to defend a certain level, like Swiss officials, giving this operation a sense of one-off, like prior attempts. That said, some of the tactics by the BOJ seemed particularly agreessive. Dollar support is seen near JPY77.50.

Six Events and a Few Things to Watch in the Week Ahead

Risk appetites returned in a big way in October, as equities, emerging markets, commodities and currencies all generally advanced and smartly so, recouping much of the ground lost in September. The events in the week ahead will likely set the tone for the month of November. They include three central bank meetings (RBA, Fed and ECB), two data points (UK Q3 GDP and US employment report) and the G20 summit.

The risk-on theme was evident prior to the somewhat improved fundamental outlook--euro zone agreement, 2.5% Q3 US GDP driven by 3.6% increase in final sales, and a rise in the HSBC PMI for China back above the 50 boom/bust level. Circumstantial evidence, including the Commitment of Traders, suggest much of the market moves have been the reduction of short positions. If new buyers are to take over the leadership, fundamental developments will likely need to not just confirm, but surpass expectations.

To Forgive is Divine

Markets rallied strongly in response to the European developments. Yet it is an exaggeration to think that this rekindled risk appetites as the whole month of October has seen equities, emerging markets, commodities and foreign currencies trend higher, recovering from their neck-breaking, wealth-destroying plunge in September. Still the advance on Thursday was impressive, helping propel the euro and the S&P 500 through the 200-day moving average, allowing sterling to test its similar moving average and pushed the dollar to yet another marginal new record low against the Japanese yen.

The market is getting ahead of itself, but the technical momentum and positioning may allow for an extension of the move. Medium term investors may need to be patient, but the fundamentals will likely reassert themselves shortly.

Look to Fade Relief Rally

Big sigh of relief that European officials delivered the bare minimum amount of details of the new plan, which are largely as had been anticipated here and elsewhere. The broad outlines consist of a 50% haircut on private sector holdings of Greek bonds, leveraging the EFSF 4-5x for firepower of around 1 trillion euros, 9% Tier 1 capital by mid-2012, and ECB not involved with EFSF and leverage.

A SPV will be set up alongside the EFSF and there is still talk that the IMF may manage it and may seek outside investors. Talk yesterday of keen Chinese interest was sparked by unnamed European official comment not Chinese. The PRC seems supportive but what this means operationally is not clear. Sarkozy meets with Chinese officials soon, but concrete commitments will likely remain elusive.

A Follow Up to the Absence of a Muni Crisis in the US

On October 4th I wrote "One Crisis that Did not Materialize", which discussed the fact that the fears of hundreds of billions of dollar losses from defualts in the municipal bond market proved wide of the mark. Many were skeptical. Here is the latest data.

The Rockefeller Institute's analysis of Census Bureau data found that preliminary data for the July-Aug period indicated that state revenues are up an average of 6.8% in the 41 states that reported early. In the second quarter, total state tax revenues increased by 10.8% year-over-year. This marked the sixth consecutive quarter of growth and the storngest annual figures since 2005.

Local governments are not doin gas well. Tax revenue has fell 1% in Q2 year-over-year and is the third consecutive quarterly decline. This is a sign of the depressing real estate market. Property taxes are nearly three quarters of local tax revenues. In contrast sales tax account for about 15% of local tax revenues.

Australia: Rate Cut Likely Next Week

Minutes from the recent RBA meeting kept the door ajar to a rate cut next week, and today's CPI figures, especially the fact that the preferred trimmed mean measure rose 0.3%, half as much as the consensus expected and bringing the year-over-year rate to 2.3% from 2.6%. Pushes the door wide open. Barring some major shock in the coming days, the RBA is poised to cut the cash rate 25 bp to 4.5% next week.

Berlusconi Cuts Deal: Et Tu Brute

Controversial Italian Prime Minister Berlusconi appears to have finally capitulated to international and domestic pressure. Press reports indicate that he has agreed to step down by January. This in turn will bring forward elections, probably to March 2012, a year earlier than Berlusconi had previously insisted.

Italy would join a number of other countries who will go to the polls or in other ways change leadership next year. This includes the US, France, Mexico, China,and Russia. Spain's election initially penciled in for next year has been brought forward to next month. It is possible that the current Greek government collapses, especially if a super-majority is required for passage of reforms that emerge from the EU summit.

D-Day for Europe? And What's Up with the Yen?

The euro has remained firm even as the US S&P tumbled yesterday, Asia stocks slip and expectations for the outcome for today's summit continue to ratchet lower. It does continue to stall out in the $1.3950-60 area. The $1.3840-50 area still marks the first level of support, though the $1.3890 area held in both Asia and Europe.

At most, an agreement in principle and some broad understandings are the most that should be expected from the summit. Further development is likely ahead of the G20 summit on Nov 3. The general shape--what seems most likely--at this juncture is EFSF as insurer for new Italian and Spanish issuance, around 100 bln euro bank recapitalization by the middle of next year, before turning to that national government and then the EFSF.

CNBC: Waiting on a European Debt Solution

Three Political Events that Should be on Your Radar

Tomorrow's EU Summit is the markets main focus. The key issue is whether European officials can finally provide closure to the two year old debt crisis and deliver the "comprehensive" and "decisive" package they have repeatedly promised. We are skeptical as governance structures and diverse interests of the stakeholders lend itself to incrementalism.

Outside of the EU Summit there are three political issues that do not seem to be appreciated by many participants. These events can have dramatic implications for the economic and financial outlook.

Choppy Consolidation: Flavor of the Day

The major currencies are in relatively narrow ranges in choppy trading ahead of tomorrow's EU summits and German parliament vote. The major foreign currencies remain firm as the North American session is about to begin.

Most attention is on the EU and euro zone summit tomorrow, but the German Bundestag vote is very important as well. The vote is on the new EFSF reform. Many of Merkel's CDU members may vote against it, according to Der Spiegel. The Social Democrats and Greens are reportedly undecided. They are more pro-Europe than the CDU, but the details of the amendments have not been aired yet.

Much Noise but Pattern Holding

The pattern in the foreign exchange market remains intake by which the major currencies often move in the direction of the recent trend and some follow through on Monday before some consolidation kicks in. The euro and sterling made new 7 week highs today in early Europe and the Australian dollar made new six week highs. However, as the European session began in earnest the currencies have surrendered their earlier gains and in fact the euro and sterling have slipped to new session lows in late in the London morning.

The poor euro zone flash PMIs did not help matters, but the focus is really on the debt crisis and the cacophony of voices still being heard. The euro zone flash mfg PMI came in at 47.3 down from 48.5. The consensus was for a 48.0 reading. The service sector flash PMI came in at 47.2 down from 48.8 and well below the consensus 48.5.

European Summit: More Talk Needed, but Something Emerging

The European debt crisis turns two years old. On average there is a crisis management summit a little more frequently than every other month on average. The most concrete and certain thing to emerge from the weekend's summit is that there needs to be at least one more before the November 3 G20 summit, which is a deadline of sorts for a resolution. The rhetoric of a "durable" or "comprehensive" solution again, proved more difficult in implementation than in declaration as did similar claims this past March and July.

Nevertheless, there has been some important progress over the weekend and additional developments are likely in the days ahead. At the same time, we note a frequent pattern in the currency markets in which Monday activity often sees follow through from Friday, before a consolidative or corrective phase ensues. The euro closed firm near its recent highs before the weekend and sterling and the Australian dollar made new highs in the recent advance. The developments over the weekend may not stand in the way of this pattern.

Europe: Your Rope

European officials simply cannot get out of their own way. They are their own worst enemy presently.

First assurances that a durable comprehensive solution would be forthcoming. Then lower expectations, with even reports suggesting that at this late date Germany could cancel the summit. More likely that they agree to some frame work now and the details at an emergency meeting next week, but ahead of the G20 summit in early Nov. No wonder tensions remain high and the Italian 10-year yield is back above 6%, a key psychological threshold.

Pessimism Grows, FX Consolidation Continues

The focus remains squarely on Europe. Concern that France and Germany are moving in two different directions undermines the already fragile sentiment and weakens expectations ahead of the weekend summit. This has kept the euro confined to the ranges carved out Monday-Tuesday--$1.3653-$1.3914. The lower end of the range seems more fragile today, but technical retracement level of $1.3621 allows a bit more slippage without doing more technical damage.

Sterling also appears confined to the ranges set at the start of the week--$1.5632-$1.5848. The higher than expected inflation report(5.2%) is slightly problematic for the central bank, which has already decided to push ahead with renewed asset purchases, but is more problematic for the government. State benefit increase (cost of living adjustment) will rise 5.2% now instead of the 4.3% the government had assumed. This is going to result in a wider deficit, all else being equal. UK retail sales figures due out late on Thursday are unlikely to change the general view of the UK economy as largely stagnant.

Thoughts on Recent Price Action and Drivers

The position adjustment and renewed risk appetite seen after a dismal September has been halted in its tracks by a combination of the more somber warnings from German officials that the sense of closure that many investors seek to the 2-year old European crisis will remain elusive despite the Berlin-Paris pledge for a comprehensive and durable solution, poor regional economic data and Moody’s reassessment of the outlook of France’s Aaa rating.

At the risk of being cynical, the lowering of expectations may reduce the chances of disappointment and actually may leave the market vulnerable to more favorable developments. Pressure on European officials to take decisive action cannot be exaggerated. The European summit this weekend may prove to simply be a preliminary exercise ahead of the G20 meeting in early November.

Preview of the Week Ahead

Corrective forces are likely to weigh on the US dollar through most of the week. The critical event will the the European summit. There is much anticipation for what has been called "durable" and comprehensive" action to address the European debt crisis.

More broadly speaking, over the last couple of the weeks the capital markets have begun correcting the large moves since in September. Equities and commodities have generally firmed, the dollar has surrendered some of its gains, core bond yields have backed up and money seems to be returning, albeit slowly, to some of the emerging markets, notably in Asia.

Outlook for European TARP

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What Winston Churchill said about America—that it can be counted on to do the right thing after it exhausts the other alternatives—seems equally applicable to Europe. It is slowly but inexorably moving toward its own version of TARP—the U.S. “toxic asset relief program”. Rather than sub-prime mortgages and related derivatives, the toxic assets in Europe are sovereign credits, which in some cases is a function of the nationalization of private sector debt.

Although Slovakia provided some last minute drama, policy makers and investors were already anticipating the approval of the reforms of the European Financial Stabilization Fund (EFSF) and looking beyond, toward implementation. The shift in the focus has helped spur a bout of position-adjusting.

Fed's Custody Data

The Federal Reserve has long competed with the private sector in offering foreign central banks custodial services (yes Brown Brothers Harriman, my employer is offers custodial services to a wide range of asset manager). The Fed reports its holdings every Thursday. Today it reported that custody holdings fell by $21 bln in the week through Wed.

This is the seventh consecutive weekly decline and over this period, custody holdings have fallen an average of about $12-$12.5 bln a week, making this past week was quite large relative to trend. It likely reflects foreign central banks selling of Treasuries to intervene to support their currencies rather than a dumping of Treasuries to diversify reserves or as a protest to such low interest rates. The decline in recent weeks appears to be the largest since the Asian financial crisis in the 1997-1998 period.

Consolidation Emerges

Since October 4th low through yesterday's high the S&P 500 has rallied almost 14%. In the same time the euro US Treasuries have fallen for six consecutive sessions before today. Some popular technical retracement targets of the down late summer down move have been approached and it should not be surprising for the markets to consolidate a bit, especially given the uncertainty over Europe, US earnings season and general anxiety over the economic and political outlook (not just in the US but globally of course).

The economic data does not really alter the macro picture. The UK trade deficit was smaller than expected but the economy remains weak and the data is not really sufficient to shed light on the key issue of more QE when the current GBP75 bln of gilt purchases is completed in Q1 12. Market rumors that Ftich was going to follow Moody's and cut the ratings of some UK banks proved on the money, but elicited only a minor reaction by investors.

Watch Italy

The domestic machinations in Slovakia will soon be resolved and passage of the EFSF reforms remains the high probability scenario. The bigger political risk may lay with Italy today.

After losing a vote that seemed largely a formality yesterday (approving last year's government balance sheet), Prime Minister Berlusconi is under pressure to hold a vote of confidence. There are press reports suggesting a vote of confidence could be held as early as today following President Napolitano's call on the Prime Minister to prove that he still has a governing majority. Yesterday's vote, a draw, could have been resolved if coalition partner Northern League head Bossi or Finance Minister Tremonti had been present. The fact that they were not has given rise to speculation of a "palace coup" of sorts.

Currency Correction Continues, Greenback Drops

The extreme market positioning leaves many long dollar holders in weak hands. The longs tried making a stand, but it has been rebuffed and the dollar is falling victim to profit-taking and stop-loss chase. Both sterling and the euro have posted new legs higher today to extend the correction that began last week.

At $1.5785 it has retraced a 38.2% of the its slide since Aug 19, when it recorded its last significant high. A move above here will likely target the $1.5950-$1.6000 area. Supportive near-term technicals would include the crossing of the the 5-day moving average above the 20-day today, for the first time since late Aug.

Gold, S&P, and the Euro: Correlations Revisited

(This follows up on this post.) The elevated volatility levels have made for difficult times for many investors. To simplify the complexity, there is much reference to risk-on and risk-off. We look at the correlations (60-day rolling correlation of the percentage change) between gold, S&P and the euro and find a more nuanced and varied relationship than many intuitively assume.

Wild Card for Tuesday--Slovakia ?

Slovakia could very well be the wild card for tomorrow. Thumbnail sketch--4-party governing coalition split on it. Slovakia would be on the hook for 7.7 bln euros 1 percent funding. Sounds like peanuts maybe...but Slovakia's GDP is only around 65 bln euros. The cabinet met for three hours today and failed to reach an agreement. The vote is scheduled for tomorrow.

One key seems to be the SaS Party. It has 22 seats and without these the government would not have sufficient votes. The coalition together has 79 votes in the 150-member chamber. The government may try to have a vote of confidence over it, meaning not to vote for it means the government collapses. SaS Party is willing to vote for the EFSF if it could get the other coalition parties to agree to vote against the ESM--the permanent mechanism that is to replace the EFSF. The other coalition parties have refused.

Same Drivers, New Targets, Be Careful of Turn Around Tuesday

Thin market conditions and extended positioning is producing a most dramatic reaction in the foreign exchange market. The initial targets suggested here for the correction have been either achieved or neared much sooner than expected.

Here are the next objectives. A move above $1.3700 in the euro would target $1.3850 and then possibly $1.40. A move above $1.5725 in sterling would target $1.5860 and possibly $1.60. The Australian dollar have moved above parity. The next target is about $1.0075 and then $1.0240. The Canadian dollar is also recovering. The greenback can test the CAD1.0170-CAD1.02 area and then possibly parity.

Corrective Pressures Unfold, Lift Equities and Commodities, Weigh on Dollar

The market misread the Fitch downgrade of Italy and Spain before the weekend. The rating agency was largely lagging the other rating agencies and the market. With Tokyo markets closed, it was fairly easy to extend the pre-weekend euro losses, but with talk of European bank recapitalization, Merkel and Sarkozy's pledge for new and bolder action by November 3 helped the corrective forces regain control of the euro and tend it through the $1.3500-25 resistance area encountered Friday.

When I first identified the risk of an upside correction earlier last week, I highlighted the $1.3600-$1.3700 area. This still seems like a reasonable initial target. Market positioning using the Commitment of Traders as a proxy warns that the short-term trend following, momentum traders stretched--very short euros and sterling. The corrective forces are also seen in the commodity prices, which in general are up for the fourth consecutive session, as are European shares (Dow Jones Stoxx 600). The cost of swapping from euros into dollars is lower for the third session.

Bloomberg: Zandi, Chandler on U.S. Economy, European Crisis

Quick Word on Jobs Data

I had thought I had gone a bit out of the limb warning of the risks of a stronger than expected report and that the stronger the report the worse the dollar would perform. Instant gratification, but with holidays in the US, Canada and Japan on Monday, the market may not significantly extend the dollar's decline ahead of the weekend. However, short-term momentum and trend followers are probably still net short the euro, though some nimble players have reversed ship.

The employment data is only good becasue expectations have been so depressed. The 103k headline increase and 137k private sector increase are not spectacular by any stretch of the imagination. The August series was revised up by 57k and the July report by 42k. The work week increased by 6 minutes and this is worth say around 350k full time equivalent and hourly earnings rose 0.2%.

Jobs Featured

The US jobs report is obviously the main event today. It is one of the most difficult high frequency data to forecast. While cognizant of the uncertainty and slack in the economy, I think the risk of an upside surprise is greater than it may appear. I say this primarily because the recent string of US economic data has surprised on the upside. Economists have been slow to recognize that the economy appears to be expanding at around 2.5% in Q3 not contracting.

Ironically, the stronger the report, the more the dollar's downside beckons. Risk appetites would be strengthened. This will allow the correction that began yesterday to continue with a target close to $1.36-$1.37. A weak report would be less surprising and likely a less dramatic market reaction. An other outright decline in aggregate hours worked would also fan anxieties. Many of the major foreign currencies, including the euro continue to track the S&P 500 closely.

BOE and ECB: What it Means and What is Next

The Bank of England, which has a penchant for surprising the market, choose not to wait for the quarterly inflation report to provide cover, and announce GBP75 bln additional bond purchases over the next four months. Although many recognized it was possible, only 11 of 32 economists surveyed by Bloomberg expected the asset purchases to be announced. Moreover, the recent data, which included stronger than expected manufacturing and service PMIs seemed to discourage the undecided. It will buy GBP25 bln of gilts across a range of maturities in three weekly auctions.

Previously the BOE bought GBP200 bln gilts between March 2009 and Feb 2010. Six months ago, many observers had expected the BOE to have to hike rates in the face of the persistence of inflation above target. Indeed inflation remains above target. The 4.5% headline of CPI in August matches the peak since the late 2008 and Lehman's failure. Nor is it clear that UK inflation has peaked. Many expect inflation to peak nearer 5%.

China Bill: Huff, Puff and Bluff

US national elections are 13 months away and not coincidentally, the Congress is looking at a new measures to encourage China to re-value the yuan. While there is little doubt that the yuan in under-valued, though reasonable people may differ on the magnitude, politics more than economics appears to be the driving force.

The most important threats to US prosperity lies within its borders. The de-leveraging of the household sector, the continued depression in the housing market, and extreme divergence between wages and salaries on one hand and profits on the other hand are not the result of the misalignment in the currency markets.

Position Squaring Featured Ahead of Key Events, Data Shrugged Off

The euro has been the biggest beneficiary of the bout of position squaring ahead of tomorrow's ECB meeting. The move began yesterday and has survived the three-notch downgrade of Italy's sovereign rating by Moody's and a new erosion in the service sector PMI (to 48.8 from the 49.1 flash reading and 51.5 in Aug)and poor Aug retials sales (-0.3% on the month, -1.0% year-over-year).

Ideas that Greece may have sufficient funds to last through mid-Nov and reports that European countries are discussing a synchronized bank recapitalization plan may be being seized upon as a reason to square up extended short euro positions.

Greece Runs out of Money, but When?

Currency in Crisis

Troika officials have postponed for the second time the decision on the next tranche of Greek aid under the 2010 agreement. While this seems to tempting the fates and fanning fears of a default, it does not appear that Greece needs the money until the mid-Nov, the new time frame for the Troika's decision. The postponement is probably best understood as part of the brinkmanship tactics that maximize the concessions from Greece.

Earlier today Greek Finance Minister Venizelos indicated that Greece has sufficient cash reserves for redemptions, pensions and salaries until mid-Nov, which incidentally is when the Troika now says they will have their decision.

One Crisis that Did Not Materialize

A little more than a year ago, many investors were worried about the US state and local government finances. There were genuine concerns that what was happening in Greece could very well be the future of numerous US local governments. Yet the much forecast debt crisis of US city and state governments failed to materialize.

While Greece and other peripheral countries in Europe are paying close to record yields, despite ECB bond purchases, US states and municipalities are paying the lowest interest rates in a couple of years. As of the late in Q3, local governments defaulted on a little more than $1 bln this year. This is about a quarter of last year's total. Some analysts were predicting hundreds of billions of dollar in defaults.

Turn Around Tuesday Falls Flat

The counter-trend moves often seen on Tuesday is falling flat today. The euro fell to the $1.3145 before finding a bid. A break here will target the $1.3045 area, the 61.8% retracement of the euro's rally that began in early June 2010, the last time the euro was below the $1.20 level. On the top side, the $1.3225-50 may be sufficient to cap.

Sterling has not been helped by the weaker than expected construction PMI. The 50.1 reading compares with consensus expectations for 51.5 and August's reading of 52.6. Gilts are rallying strongly as speculation increases of renewed asset purchases. 10-year gilt yields are off 11 bp and the 30-year gilt yield has fallen 14 bp.

Chutes and Ladders: Preview of BOE and ECB Meetings

The Bank of England and the European Central Bank meet this week. There is much speculation that both can alter policy. We suspect there may be risk for disappointment, but that disappointment with the BOE, could trigger a bounce in sterling, while disappointment with the ECB could see the euro sell-off.

The outcome of the Bank of England meeting will known first. Based on the dovish cast to the Sept BOE minutes and some recent comments, within the context of generally soft economic data, there is speculation that the BOE can resume its asset purchases program with a GBP50 bln purchase over the coming few months. This seems to be the consensus.

Hardly Calm, but Storm Comin'

The US dollar is beginning what could be a momentous week on generally firm footing. The European finance ministers meet today and RBA, BOE and ECB meet later this week and the US reports jobs data at the end of the week. The Japanese Tankan and European manufacturing PMIs do nothing to weaken growing pessimism about the world economic outlook, but the highest Chinese PMI since May reinforces the soft landing hypothesis. Arguably Australia has become increasingly decoupled from China as its PMI fell further in Sept and now is below 50 for the third consecutive month. At 42.3, it is at its lowest level since mid-20009.

Sterling's 50-day moving average fell below the 200-day average on Thursday last week. It is the first time in about 13-months. It is not a short-term technical signal but reflect the 7.75% depreciation since the middle of August. Support is ahead of the lows for the year set in late Sept near $1.5320. Below there, support is seen just ahead of $1.52, a Fibonacci retracement objective.