Greece holds all the wrong cards

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Tuesday was the day that this crisis became too big for the EU to handle. By calling a referendum on last week’s rescue deal for Greece (the cabinet approved last night), Greece is putting itself onto a path of forced default, which could even happen before the referendum (see below for the numbers).

It’s worth noting that the last referendum in Greece was in 1974 (on the abolition of the monarchy) and there were no referendums on EU or euro membership. The price action in bonds yesterday was extremely instructive. UK gilts railed more than 20bp, German bonds by 25bp. French yields were down, as were Dutch, but Belgian, Italian and Spanish were all higher.

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Italy’s premium over Germany reached a new record at over 440bp, Right now, the focus falls on the confidence vote in the Greek parliament at the end of the week and the gathering of G20 leaders in France, but events are unfolding too fast for the G20 to be able to save the day.

Commentary

The Greek numbers.  By calling a referendum (which may yet not happen) and pencilling this in for January (although interior minister today saying it may be December), Papandreou must have made at least one of three assumptions. Firstly, that the government will have enough cash to see it through to at least the end of January based on better knowledge than ‘back-of-the-envelope’ calculations. Secondly, that the troika (EU/IMF/ECB) will continue with its lending program regardless and will start monitoring/negotiating its next (7th) loan tranche payment. Thirdly, that the voluntary debt restructuring agreed last week (50% haircut on privately held debt) will be agreed in December and include the end-December issues (market pricing suggests that market does not believe this will be the case), on the assumption that the referendum will not include this element. But for the EU and IMF to consider lending more to Greece with a referendum pending would be ill-advised in the extreme. A rejection of the deal agreed last week to secure a new bailout package would effectively put Greece on a path towards default. The bottom line is that either Papandreou has some fiscal trick up his sleeve to improve the budgetary numbers in the next two months or he’s taking a calculated risk on one of the three assumptions above. If there’s nothing up his sleeve and if his gambles do not pay off, Greece will most likely default in the early part of next year and in a fairly ugly fashion.

Euro-woes aid the pound. The fundamentals are dreadful; the economy is skirting with recession; the country is saddled with huge debts; fiscal austerity and falling real incomes are weighing heavily on confidence and yet, the currency is actually holding its own. Renewed doubts about Europe’s latest response to its sovereign debt and banking crisis have provided the pound with considerable impetus this week – EUR/GBP is now trading below 0.86, a one-month low, down from 0.88 on Friday. Both investors and traders appear to regard the pound as a safer bet than the single currency these days. They also respect the fact that the government has been prepared to stick with fiscal austerity despite the obvious suffering it represents for consumers and businesses. This respect extends to the gilt market – the 10yr gilt yield is down a further 12bp this morning at 2.32%. Gilts have been an incredible investment this year – back in February, the 10yr yield was 3.7%. Should Europe continue to crater, then it would not be surprising if sterling benefited further, notwithstanding the immense domestic economic and financial challenges.

MoF spends big to stop yen gains. Do not let it be said that the MoF is not heeding the shrill cries from its huge export sector regarding the strength of the currency. After spending nearly USD 58bn back in August, the size of BoJ intervention yesterday appears to have been at least USD 50bn and may have been double that (according to the Asahi newspaper). The response of the currency to this intervention has frankly been poor, in part because it has been badly handled. Not long after the central bank had completed its second round of large-scale purchases of dollars on Monday, BoJ head Shirakawa suggested that the nominal effective exchange rate was actually not that strong, in effect undermining the premise for the intervention and moreover implying that the MoF and the BoJ did not see eye to eye on the need for such strong action. For its part, the MoF may remain determined, with significant financial resources still at its disposal. However, in a world where many of the major currencies have serious doubts attached to them as a reliable store of value and with question-marks over the safety/security of their banking systems, it is hardly surprising that the yen has so many friends.

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