Markets Stabilizing after Initial Reaction

The markets initially responded dramatically to the weekend new of the Greek referendum, capital controls and an extended bank holiday.  The markets quickly stabilized and have recovered a bit in the European morning.  The Swiss National Bank confirmed intervention to limit the franc rise.    

Meanwhile, the cut in China's interest rates and reserve requirements, also announced over the weekend, failed to prevent a continued slide in Chinese shares.  The Shanghai Composite lost 3.3% while Shenzhen was off 6%.   The former is off almost 25% since the June 12 peak; it is still up 25% for the year.  It is it hard to apply the conventional rule of thumb of a bear market as a 20% fall.    Although we argue that the weekend rate cut was driven by several considerations, the precipitous fall in the equity market was surely a key factor.  

Reports indicate that regulators are considering suspending initial public offerings to help stabilize the market.   There are at least 28 IPOS (which could see as much as CNY4 trillion liquidity tied up) starting later this week.   There is much precedent for such a measure. 

While Chinese shares finished off their lows, the same was not true in Japan.  The Nikkei gapped lower and settled on its lows with a 2.9% drop.    It probably did not help matters that industrial output slumped 2.2% in May.  The Bloomberg consensus was for a 0.8% decline.  On the other hand, retail sales rose 1.7% in May.  The consensus was for a 1% increase.  

European equity markets saw sharp initial losses, but most EMU markets have stabilized with losses of around 3%. The FTSE and other European markets, outside of EMU, off 1-2%.    The early call is for the S&P 500 to seen around a 1% loss at the opening. 

Core bond markets have rallied strongly but are also off their best levels. Near midday in London, the yield of 10-year Treasury and bunds are off 13 bp.  Gilts are off 12 bp.  Peripheral bond markets are 14-20 bp higher but have also stabilized.  

The economic reports have been overshadowed by the political developments.  However, Spain reported that after 11 months of deflation, the preliminary EU harmonized measure was flat in June.   In contrast, German states that have reported June figures have all reported declines, confirmed that the national rate is likely to ease from the 0.7% pace seen in May. 

European officials were caught off-guard by the Greek move.  While we recognize that OMT has been recently ruled within the ECB's mandate and sovereign bond buying is an ongoing operation (though it does not appear that the acceleration indicated several weeks ago has materialized).  We recognize that the institutional capacity has grown for the EU and ECB.  Yet we remain concerned about the possible fallout from a Greek default and/or a Greek exit from EMU. 

Recall that during the early days of the crisis, Greece acted almost as an SIV for European governments to protect their banks, which held billions of euros of Greek bonds.  Rather than face numerous potential Lehman-like events, European governments lent Greek funds primarily so it could service its private sector debt.  Therein lies how European tax payers were put at risk.  

What this means is that the Germany direct exposure to Greece is about 57.2 bln euros.  France's exposure is almost 50 bln euros.  Italy's near 37.8 bln and Spain is just over 25 bln euro exposure to Greece. 

There are a couple of political circuit breakers that would prevent the referendum, but the odds seem long.  Former Prime Minister Samaras has submitted a motion for a confidence vote.  If the government loses it, a unity government could cancel it.  Alternatively, the President could refuse to sign the motion, or he could resign, as he has threatened.  

This would also freeze the referendum until a new president, with a majority of parliament, would assume office.  However, the fact that the referendum was approved by parliament makes it a type of confidence vote.  It is understandable why a president would not feel comfortable overruling parliament. 

Merkel, as is her style, has been quiet as the crisis accelerated in recent days.  This may end today.  It has been clear throughout recent months that the finance ministers could not reach an agreement.  Although many observers and the media are making the referendum on EMU membership, we are not quite their yet.  

The referendum is about accepting conditions of an offer regarding the second aid package that expires tomorrow.  Despite the government's push for a "no" vote, the polls suggest the "yes" camp is ahead.    A "yes" vote would likely topple the government.  A "no" vote would not necessarily trigger a Greek exit from EMU.  The Greek government is essence appears to be saying that it would rather not lead Greece if there is no alternative to the creditors' demands.   

Meanwhile, more immediately, the IMF payment is due tomorrow.  Many now think Greece will miss it and slip into arrears.  While the rating agencies are unlikely to take immediate action, European creditors could respond.  The fog of uncertainty makes for fragile markets. 

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