Over the past week, investors from every asset class and every country have turned their focus over to the financial stability of Greece. The direct impact that a default from this single economy could have on the US or most other economies is limited; but when the market is already predisposed to threats to global financial stability, the threat is amplified.
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[B]The Economy and the Credit Market[/B]
Over the past week, investors from every asset class and every country have turned their focus over to the financial stability of Greece. The direct impact that a default from this single economy could have on the US or most other economies is limited; but when the market is already predisposed to threats to global financial stability, the threat is amplified. The resulting uncertainty reverses carry trade flows and bolsters demand for liquidity, both of which support the US dollar. As the market’s premier safe haven and given the sheer volume of carry interests that developed through 2009 (a significant portion of which was funded through cheap dollar-based loans); there is ample potential for a move towards risk aversion to bolster the greenback. However, this single event alone could lose steam relatively quickly. Would a meaningful bailout of the Greece fundamentally alter the course of underlying sentiment? Unlikely. The general conditions of fear and uncertainty is what has intensified the market’s distress when it comes to this economy’s potential default. In the meantime, while risk appetite carves its unpredictable path, the medium-term focus will shift increasingly towards the fundamentals that back the currency. Growth and interest rate potential are the biggest concerns for traders after risk appetite. A strong pace of annualized 4Q growth and a drop in the January unemployment rate has put the US further along the recovery curve. What’s more, the market is pricing in 72.5 bps of hikes over the coming 12 months (more than all the majors except the RBA and RBNZ).
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[B]A Closer Look at Financial and Consumer Conditions[/B]
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Financial and credit market stability have been thrown into doubt over the past week with an exaggerated focus on the potential for a Greek default. Under normal circumstances, the country could very well reach its aggressive deficit cutting goals. However, with investors scrambling for safety of funds and otherwise increase the risk premiums on assets of all kinds; the real consequence of higher financing for countries is starting to bear out. Furthermore, behind Greece, there are many European Union nations that are struggling to survive the strict guidelines of being a member of the collective. Though, in the end, Europe is simply a lightning rod for risk aversion that is naturally required to balance market values with fundamentals. There are few that would argue that the US economy is on track for recovery; but the projections of pace are a matter of considerable debate. Not a few weeks ago, the government reported the world’s largest economy grew at a 5.7 percent annualized pace through the 4Q. Adding to this optimistic outlook, the January unemployment rate marked its biggest drop in over 11 years when it fell to 9.7 percent. However, both of these improvements are relative. The strong pace of growth is compared to the deep recession of a year ago and there are more than 8 million Americans that lost jobs through 2007 and 2008. Of course, for the markets, this pace of recovery could still be considered remarkable when compared to other economies.
[B]The Financial and Capital Markets [/B]
Volatility was the primary trait of price action in the financial markets this past week. However, through it all, there was still a general bias towards risk aversion. The threat that Greece may default on its debts or otherwise withdrawal from the European Union so that it can stabilize its economy has taken center stage; but this is just a readily accessible focal point for a market that is already sensitive to risk rather than a potential catalyst for a financial crisis. As the world’s financial markets continue to work down the premium built up through most of the past year; the financing that speculators, companies and governments have come to rely on will grow more expensive. In turn, the tangible growth the recovery in capital markets has provided to the world’s economy will dry up; and there will be a true test of investors’ convictions and the efficacy in governments’ efforts to foster stability and recovery. So far, the markets have only corrected a modest percentage of the premium that was priced into the markets since the world started to pick itself up from the worst crisis in memory. If there is indeed a sustained decline in sentiment, the markets will certainly suffer for it.
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[B]A Closer Look at Market Conditions[/B]
The capital markets have maintained a bearish track for over a month now; but the troubles in Greece have enabled investors to focus their concerns. Over the past week, the benchmarks for the various speculative markets have extended their respective bear waves; but a side effect of the focus in Europe has also increased the sensitivity to the day-to-day developments in the situation. Recently, speculation that the EU or Germany would offer Greece a bailout has generated a sense of confidence. However, offering guarantees or even loans to this one country does not the troubles that the broader region faces, much less the world. While the bearing of trend for the markets takes a greater amount of time and conviction to mark a meaningful turn; some of the more simple volatility readings react more readily to short-term changes in sentiment. Therefore, with the early signs that a bailout in Greece is on the way, the CBOE VIX index has been able to ease back from three month highs and the DailyFX Volatility Index has fell back from its high for the year. However, to acquire a true sense of risk, we have to look at the more rooted indicators. Risk premium in junk bonds and credit default swaps has turned on to a steady pace of growth. What’s more, capital leaving highly speculative instruments is going to short-term government paper.