Redenomination Genie Remains Out of the Bottle

The US dollar is trading with a firmer bias today, but largely remains confined to recent ranges.  Sentiment remains cautious.  Participants seem to lack a near-term focus, but the failure of the foreign currencies to build on last week's gains is a bit disappointing, though the pullbacks have been shallow.

Global equities are mixed.  The MSCI Asia Pacific Index rose about 0.3.  While the Nikkei rose to a four week high, following a larger than expected current account surplus for June, which helped boost exporters, the China's shares gave up most of the early gains ahead of tomorrow's inflation reports.  European bourses are lower, with the Dow Jones Stoxx 600 is off almost 0.5% near-midday in London and all the major sectors are under water.   Spain and Italy's 2-year yields are pushing higher for the second day.  The 10-year sector is more mixed, with the Spanish 10-year yield up 9-10 bp while Italy is flat to slightly lower.

The UK and Germany surprised the market today.  The BOE's Quarterly Inflation Review was indeed dovish, but not as dovish as many expected and Governor King's fear that a rate cut could be counter-productive and that the 0.7% contraction in Q2 GDP was exaggerated, helped sterling recover from the earlier decline.  Germany's 0.9% drop in industrial output could have been worse given the 1.7% decline in orders, reported yesterday.  Separately Germany reported a larger than expected trade surplus (17.9 bln euros vs consensus of 14.6 bln).  However of note, both imports and exports fell suggesting that net exports may have been a drag on Q2 GDP which is to be reported on Aug 14.  

Draghi has identified two challenges.  First was what he says is the broken transmission mechanism of monetary policy.  We have argued that the rise in peripheral yields is more a function of the reluctance of private sector investors in the creditor nations to recycle their surpluses back into the deficit countries.  In any event, his threat of official action has succeed in driving down peripheral yields.  This action reduces any immediate pressure on Spain and/or Italy to formally seek assistance, which Draghi clearly said was necessary to if the ECB was going act as well.  

The second challenge appears less susceptible to verbal jousting or actual official purchases of sovereign bonds.  It is what we have called re-denomination risk.  It is difficult to measure the perception that a country will drop out of EMU.   Predictive markets, like www.intrade.com, may be flawed, but provide some insight.  The odds for a country to leave by the end of this year or by the end of next year are relatively high given the recent history at 39% and 56% respectively.  This is the upper end of this year's range, except for the period around the Greek elections.  

The negative interest rates in several European countries cannot really be accounted for by QE, but rather reflects fear of euro zone disintegration.  Euro area countries with negative 2-year yields are those countries that investors expect to have currency appreciation if the euro zone were break-up" like Germany, Netherlands and Finland.  Investors are on the fence about Austria and the two-year straddles zero.  Switzerland 2-year yield has moved the deepest into sub-zero territory.  Many expect the franc to appreciate markedly in a break-up scenario.  The same is true to a less extent of the Denmark. 

Another reason why this risk is not going away is that officials continue to talk about it, despite Draghi's insistence that the euro is "irreversible".  Look at what Eurogroup head Juncker said on Tuesday.  When asked about Greece leaving, he tried to reassure, he said certainly not before the autumn, which is when the Troika makes their decision.  Juncker's finished the thought, according to press accounts by adding "...and still not even then".  However, that was less than convincing as he opined that a Greek exit would be manageable even if not desirable.  A Greek exit is more likely to increase perceptions of re-denomination risk rather than reduce it, even if European officials repeat their mantra that Greece is unique.  
Redenomination Genie Remains Out of the Bottle Redenomination Genie Remains Out of the Bottle Reviewed by Marc Chandler on August 08, 2012 Rating: 5
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