Greece On A Knife's Edge

Late last week the credit markets eased off in their run on Greek government debt and CDS on same, following the reaffirmation by France and Germany of their intention to extend support to the beleaguered Greek government.

Over the weekend the brinkmanship that has frequently preceded previous aid disbursements to Greece continued, with euro area finance ministers postponing an undertaking to release the next bailout tranche and instead stressing that it may well not be paid out. This was evidently done in order to force the Greek government to make fresh commitments which in turn will make the release of the bailout tranche easier to sell to the domestic electorates of the other euro-area members.

In addition there seems to be growing resignation regarding the ability of Greece's government to fulfill the conditions of the bailout. The probability that the EU/IMF/ECB 'troika' will cut its losses was never higher than it is at the moment.

Meanwhile, Greek prime minister Papandreou's PASOK government stands on ever weaker legs. The conservative opposition is adamantly opposed to additional tax hikes and demands new elections (not surprisingly, it leads in the polls). The government has so far refused to downsize the public sector on account of the fact that it is home to its political power-base, but public resistance against the austerity measures is growing anyway. Papandreou has canceled a planned flight to the US to host yet another emergency cabinet meeting over the weekend.

A good summary of the weekend's developments is provided by Business Week/Bloomberg, while this story in the NZ Herald focuses on the latest problems the ruling PASOK government faces due to increasing doubts about its ability to enforce tax compliance.

An already half-forgotten former player in international interventionism, the once deemed 'irreplaceable' ex-IMF chief Dominique Strauss-Kahn also added his two cents in an interview he gave over the weekend, opining that 'Greece simply can't pay', which is of course entirely correct. He recommends to simply let the default proceed, which is interesting mainly because he was firmly in the pro-bailout camp back when he still ruled the roost at the IMF.

It seems likely that vulture investors decided on Friday to step in and buy some Greek government debt. With two year note yields at one point almost reaching 80% and one year yields reaching an astonishing 143% last week, vultures may well figure that it is worth taking a small bet on Greek government debt based on the idea that even in the event of a default, expected recoveries would make such an investment worthwhile.

Greek finance minister Angelos Venizelos (whose main function is to keep PASOK's backbencher rank and file in line) and prime minister Papandreou continue to insist that they will do whatever it takes to get the bailout funds flowing again. Given that the bulk of these funds is used to service existing Greek debt and pay it off as it reaches maturity, it is no wonder that others in the EU are beginning to wonder whether simply bailing out their own banks may possibly  be a more sensible option (of course nobody thinks that the banks won't be bailed out. That is simply not 'allowed').

The problem with this train of thought is of course that one cannot be certain in what ways an official default by the Greek government may redound on the wider economic and financial landscape. For instance, Greek banks have, via their subsidiaries, become major lenders in several CEE nations. Banks from Austria are major lenders to CEE nations as well. Conceivably a credit freeze in these nations could have debilitating effects on economic performance and worsen the position of other lenders. We are just naming this as an example of how the default could lead to as-of-yet unexpected consequences. Our friend Toni Straka at Prudent Investor has written an interesting update on the numerous risks Austria's banks are facing.

In addition, the lately somewhat more hopeful performance of the other peripherals under the EFSF umbrella could still deteriorate, especially in view of  the recent weakening of economic activity across the euro area. In short, the currently widely held view that Greece can be 'contained' may yet turn out to be wishful thinking.

This is important in view of the fact that the euro area's banks remain in dire need of more capital. Last week's announcement by several central banks that dollar liquidity would be provided to the euro-land banks until the end of the year after all doesn't really change their precarious position in this respect.

 

Spain Not Out Of the Woods Yet

Consider what the prospect of a Greek default has done to the share prices of France's biggest banks, which are known to have the biggest direct exposure to Greek government debt in Europe. As a result, Moody's has already downgraded these banks. However, the problems the French banks potentially face go well beyond Greece – as we noted in a recent update, they hold some € 140 billion in Spanish debt and € 400 billion in Italian debt. Overall, the liabilities of the three biggest French banks (Credit Agricole, BNP Paribas and Societe Generale) amount to €4.7 trillion – 250% of France's GDP.

Note in this context a recent post by Mish on the growing financial difficulties of Spain's regions. This is highly relevant, as Spain's regions handle about one third of public spending in the country. As Bloomberg reports, Spain's regional budget deficits have just climbed to a new record of 12.4% of GDP.


“Spanish regions’ debt burden surged to a record in the second quarter, adding to pressure on the central government to rein in spending or risk missing the nation’s deficit goal.

The 17 semi-autonomous regions’ outstanding debt burden rose to 133.2 billion euros ($183.7 billion), or 12.4 percent of gross domestic product, from 11.6 percent in the first quarter, the Bank of Spain said on its website today. From a year earlier, the debt surged 24 percent and the outstanding amount has more than doubled since 2007.

Spain’s regions are key to the nation’s efforts to cut the euro area’s third-largest budget deficit as they manage more than a third of public spending, including health and education. Fitch Ratings downgraded five regions including Andalusia and Catalonia this week, saying debt levels are climbing and the weak economic recovery will undermine revenue.

Spain’s regional governments are behind schedule to meet deficit targets, according to data released last week that Moody’s Investors Service called “credit negative.” Slippage by the regions “adds to pressure on the central government to make the needed cuts to meet the general government deficit targets,” Fitch Director Douglas Renwick said on Sept. 13. Risks to Spain’s sovereign rating are “clearly on the downside,” he said.

 

(emphasis added)

As this happens just as economic activity weakens again all over the euro-area, a further deterioration of budgets can probably expected, as tax revenues are set to once again decline. Furthermore, we believe that the bursting of Spain's real estate bubble continues to hang over the banking system and has essentially 'zombified' it.

 

Market Reaction

European markets reversed from an earlier bounce on Friday and surrendered some of their gains as it became increasingly clear that a decision on the Greek bailout would be postponed. For instance, among the aforementioned French banks, BNP's stock went back into negative territory after initially continuing its recent bounce. The same fate befell the EuroStoxx bank index.

 


 

Shares in BNP Paribas reverse on Friday from an earlier bounce – click for higher resolution.

 


 

The Eurostoxx bank index pulls back again – click for higher resolution.

 


 

European stock markets ended the week with a 'spinning top candle' and failed to overcome their downtrend lines, as evidenced by the chart of Germany's DAX index below:

 


 

Germany's DAX – the bounce runs into resistance on Friday – click for higher resolution.

 


 

At the time of writing, stock markets in Asia found themselves under considerable pressure again (with the exception of Tokyo, which is closed for a national holiday), along with weakness in S&P and euro futures, and strength in gold futures and the dollar index. Whether this trend is sustained into the European and US open remains to be seen, but this is what the landscape in Asian markets looked like some three hours prior to the open in Europe:

 


 

Asian stock markets on Monday shortly after 6:00 CET. The Hong Kong market had just closed when this snapshot was taken – click for higher resolution.

 


 

The S&P 500 December futures lose 12 points in Asian trading – click for higher resolution.

 


 

The euro September futures contract falls back to the lows of last Wednesday – click for higher resolution.

 


 

Gold (December future) continues to be well bid in Asia on Monday – click for higher resolution.

 


 

Below we have indicated two possible speculative paths for the S&P 500 that only differ in the details, but not in their essence. The underlying assumption is that a cyclical bear market has begun. There is of course considerable uncertainty attached to any such forecast at the moment, as the outcome depends crucially on the further near term developments in the euro area debt crisis and on what the FOMC will dish up this Wednesday.

Our impression from anecdotal evidence is that the markets have by now 'priced in' an announcement of an 'Operation Twist' type move to lower long term market interest rates by shifting the composition of the Fed's balance sheet toward longer term debt instruments from shorter term ones (why this would be thought to 'do the trick' remains mysterious to us). The risk for bears is that something more forceful will be announced, while the risk for bulls is that less than what is currently expected is announced.

One should therefore take the 'possible paths' suggested below with a grain of salt – they are little more than a guess. Should the index overcome resistance in the 1250 region and establish a firm foothold above this level, a reassessment will be necessary. Overall our impression remains that the near term sentiment picture is somewhat supportive of another short term rally attempt, while the medium to long term outlook seems fraught with considerable risk.

 


 

The S&P 500 with two possible, albeit both ultimately bearish paths indicated. The important resistance (red dotted line) and support levels (green dotted lines) are indicated – click for higher resolution.

 


 

There has lately been a very close correlation between the US 10 year treasury note yield and the DAX, which shows that demand for treasury debt is closely correlated with the the ups and downs produced by the euro area debt crisis.

 


 

The 10 year treasury note yield and the DAX (green solid line) overlaid. The DAX is slightly more volatile, but directionally the two are currently closely aligned – click for higher resolution.

 


 

If the above idea regarding the stock market plays out, then we can probably also expect more dollar strength to eventuate. As shown below, the dollar index has overcome a near term resistance level last week and has just absolved a – so far – successful test, transforming it into near term support. This view could potentially be waylaid by Wednesday's FOMC decision, but for now the chart would suggest more dollar strength (and concomitant euro weakness) is in the offing.

 


 

The dollar index with a possible post break-out path indicated. Whether this plays out as envisaged here will also depend on whether the markets decide to focus more on easier Fed policy or on the crisis in euro-land – click for higher resolution.

 


 

Among the things that keep us wary of the outlook for the stock market  is the weakness in industrial commodities. Below we show a daily chart of copper, which has recently returned to a region of lateral support after making yet another lower high.

Copper is supported by frequent supply disruptions and positive analyst views on the supply-demand picture which are mostly grounded in the notion that new mine developments are coming on stream too slowly to make up for the reduction of production due to upcoming closures of aging existing mines.

On the other hand, copper is pressured by the perception that global growth is weakening, which should keep a lid on demand. Moreover, stories about the size of the so-called 'hidden' or off-exchange copper inventories continue to proliferate and the estimates that are bandied about should make copper bulls think twice.

For instance, copper expert Simon Hunt concludes from the filings several banks have made with the SEC in order to get approval for physical copper ETF's that the off exchange inventories may amount to up to 2.8 million tons of copper. As the FT Alphaville blog reports in this context, quoting Hunt:

 

“JP Morgan and Black Rock have been promoting their physical copper ETFs to potential investors on the basis that the copper market is extremely tight, that there are no hidden stocks and that therefore prices will go much higher. Both groups have made frequent filings to the SEC to obtain approval for their listings. Now comes the bombshell for the bulls. In its latest filings, JP Morgan stated that in addition to the reported circa 568kt in exchange stocks in 2010, there was a further 2.53 million tonnes in the physical market. Black Rock stated that the amount of copper in exchange approved warehouses at the end of 2010 was roughly one-fifth of total global refined copper inventories meaning that the total outside the exchange warehousing system was more than 2.8 million tonnes.

 

There have of course in the past been frequent reports of speculative copper hoarding in China, with the hoards often serving as collateral for credit lines with banks for purposes unrelated to the copper business. Such hoards are therefore held 'on margin' and there are presumably certain threshold prices at which they will be forcibly liquidated by lenders. Should copper decline below the $3.70 – $3.80/lb. zone, then we would assume that a new medium term  downtrend is definitely underway. As long as this zone of support holds, the recent ups and downs could still be classified as a consolidation, but as the chart shows, the air is getting thinner for that view.

 


 

Dr. Copper has been stumbling lately, but lateral support has held thus far – click for higher resolution.

 


 

Another industrial commodity the chart of which looks slightly dubious to us is crude oil. Below you see the recent history of triangles and wedges in crude oil since the advance into the late April high. It is by the way deeply ironic that the stocks of many gold and silver miners topped out at exactly the same time, i.e., just as one of the most important input cost items for miners began to plunge, thereby increasing mining margins. Of course the gold stock indexes have made up the lost ground in the meantime, but there are still many laggards in the group.

 


 

Wegdes and triangles in crude oil (spot WTI) since the rise into the late April high. This doesn't bode well for the likely resolution of the most recent wedge iteration – click for higher resolution.

 


 

Regarding industrial commodities we can probably state that much will also depend on how the markets interpret the outcome of the upcoming FOMC meeting relative to the still developing euro area crisis. One of the two factors will likely end up overshadowing the other, but it is obviously too early to tell what the outcome will be. Suffice it to say that we don't like the looks of these charts at the moment.

The old unweighted CRB index (i.e., the CCI) still looks like it is merely consolidating, as up until recently strength in grains and precious metals served as a counterweight to weakness in industrial commodities.

Alas, the CCI has broken below its 200 day moving average for the second time late last week, which has tilted the outlook in a bearish direction for now , although there are still layers of lateral support that may hold the correction in check.

The more energy heavy CRB index not surprisingly looks somewhat weaker than the CCI.

 


 

The unweighted version of the CRB index, the CCI – still in a sideways move – click for higher resolution.

 


 

The CRB index with its heavy energy weighting looks quite weak – click for higher resolution.

 


 

Gold continues to outperform industrial commodities and was bid up again on Friday. For now it remains in a consolidation/correction formation, possibly building a triangle.

 


Gold caught a bid on Friday, but this move hasn't yet altered the very short term downtrend. Presumably the consolidation will take some more time; note that the 50 day moving average has now risen to the 1,727 level – click for higher resolution.

 


 

Euro Area Credit Market Charts

Below is our usual collection of charts of CDS spreads, bond yields,  euro basis swaps and a few other charts. Prices in basis points, with both prices and price scales color-coded where applicable. 5 year CDS on Greek government debt have come in a tad on Friday, as hopes for the bailout to proceed briefly flared up. The recent up trend in peripheral bond yields and CDS spreads was subject to a correction on Friday more generally. Whether that will continue this week remains to be seen. As of yet, the medium term trends remain unchanged.

Euro basis swaps have begun to bounce since the announcement of the provision of unlimited dollar liquidity to euro area banks via the Fed's swap line last week, but have given up a little ground again late in the week. As several other observers have noted, this central bank announcement may well have come in preparation of an expected Greek default. We would however point out that the joint central bank statement was actually pointless in substance, since the Fed's dollar swap lines to other central banks were already renewed back in July (originally it was planned to terminate them as of August 1).

 


 

5 year CDS on Portugal, Italy, Greece and Spain – all pulling back from their recent highs. Note that due to the different scales the pullback in Greek CDS looks quite small on this chart, but in terms of basis points it actually amounted to almost 400 points – click for higher resolution.

 


 

5 year CDS on Ireland, France, Belgium and Japan – all pulling back on Friday – click for higher resolution.

 


 

5 year CDS on Bulgaria, Croatia, Hungary and Austria – pulling back only slightly from their recent highs – click for higher resolution.

 


 

5 year CDS on Latvia, Lithuania, Slovenia and Slovakia – still forming triangles – click for higher resolution.

 


 

5 year CDS on Romania, Poland, Slovakia and Estonia – click for higher resolution.

 


 

5 year CDS on Saudi Arabia, Bahrain, Morocco and Turkey – following their European brethren – click for higher resolution.

 


 


10 year government bond yields of Ireland, Greece, Portugal and Spain – there was quite a hefty pullback in Greek yields on Friday – click for higher resolution.


 



 

10 year government bond yields of Italy and Austria, UK Gilts and the Greek 2 year note. The Greek two year note has actually retreated from an interim high last week close to 80% to just above 55% on Friday, so this was a big move. Italy's yields also improved a bit on Friday, but are still worryingly high at 5.51% – click for higher resolution.


 


 

Three month, one year and five year euro basis swaps – dipping again after their recent bounce – click for higher resolution.


 


 

Our proprietary index of euro-area bank CDS (an unweighted index of 5 year CDS  on the senior debt of BBVA, Deutsche Bank, Societe Generale, BNP Paribas, Intesa Sanpaolo, Unicredito, and Monte dei Paaschi di Siena) pulls back a bit further on Friday to roughly the 337 level. This long term chart shows that it nonetheless remains at a very high level – click for higher resolution.


 



 

Inflation adjusted yields bounce a little bit, in concert with the pullbacks in peripheral bond yields – click for higher resolution.


 


 

5 year CDS on the 'Big Four' Australian banks – once again we see that ultimately, 'it's all one credit market'. When euro area sovereign CDS and CDS on senior bank debt pull back, then so do those on the banks down under. However, the situation for Australia's banks will continue to depend on future developments in house prices. At the moment it looks like the housing and associated mortgage credit bubble may be in the process of bursting – click for higher resolution.

 


 

 

Charts by:Bloomberg, StockCharts.com, BigCharts.com


 

 

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