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Daily Commentary 17/02/15

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Greek talks end with no agreement The talks between the EU and Greece ended abruptly last night with accusations of bad will between the two sides. In fact, the disagreement seems to be between Greece and the European Commission on one side and the finance ministers on the other. Greece said that the Commission had offered an acceptable path forward, but that the finance ministers changed the proposal to one that would tie Greece to its current agreement. SYRIZA was elected on a promise to renegotiate the current agreement, so of course that was unacceptable to them and Greek Finance Minister Varoufakis rejected the offer. End of talks. Dutch Finance Minister Dijsselbloem said that ministers could reconvene on Friday if there’s a breakthrough. Without a deal, Greece’s current aid agreement expires at the end of February and the country could run out of money by the end of March, and almost definitely will by the end of July.

FX market remains remarkably calm. EUR was the worst-performing G10 currency as USD gained against most, but still it was nothing extraordinary – the day’s range was 0.78%, almost exactly in line with the average of the last six months of 0.82%. The 3m ATM 25 delta risk reversal has actually moved a bit higher in the last few days, indicating that EURUSD puts are becoming a little bit less expensive relative to calls – in other words, demand for insurance against a falling EUR is weakening. Apparently FX investors still believe a solution will be found (as do I), although investors in the Greek stock market are not so confident. I would still expect more fireworks and volatility – and another leg down in EURUSD – before a solution is found.

What options does Greece have? The easiest one would be to accept an extension of its current program. That would mean continuing the reform measures that are already promised, such as privatization, tax collection, cuts of pensions, reduction in the number of government employees, etc. As mentioned above however, SYRIZA won the election promising not to do this.

Greece has also threatened to turn to Moscow or China for the money. Moscow has indicated that it’s ready to help, but this is not a move to be taken lightly. Russia might demand a naval base in Greece in return, which could threaten Greece’s membership in NATO. This would not be the preferred solution for Greece, I assume.

Another possibility that academics are suggesting is for the government to issue a parallel currency to fund its operations while they continue the negotiations. This would be an IOU redeemable in euros at some point in the future when the money starts flowing again. There is some precedent for this even in the US, where some states – which are not allowed to run budget deficits – have done this to fund themselves temporarily. However, people might take this as the first step to creating a new currency and leaving the Eurozone. It could precipitate a bank run and financial chaos.

There are other technical matters that Greece can bring up as well to get the finance ministers to agree to allow the country greater access to funding, but these are not long-term solutions.

Looking at these possible solutions, #2 and #3 seem politically difficult and #4 is only a way of delaying the inevitable, so I think it comes down to #1. They will have to find some face-saving way to make Greece accept the current program without it appearing that they are accepting the current program. Officials have said they are already 70% down this road, but there are still 30% of the items that they can’t agree on. One way to square this circle might be just to rename a lot of the things that upset the Greeks, such as changing “program” to “contract” or something like that. The main sticking point seems to be political, and not just from Germany: the governments of the other peripheral countries, which have also endured wrenching adjustment programs, don’t want their voters to think that they went through all that austerity only because their representatives weren’t good negotiators. As European Commission President Jean-Claude Juncker said once, “We all know what to do, we just don’t know how to get re-elected after we’ve done it.” That applies to both sides in this case.

RBA minutes show doubts on domestic demand, China The Reserve Bank Australia (RBA) released the minutes of its February meeting. This was the meeting where it cut its benchmark interest rate by 25 bps. The minutes showed that doubts about a pickup in domestic spending and China’s demand for raw materials were behind the decision. The RBA still feels AUD is too strong, which it may well be, looking at various PPP valuations. I remain bearish on AUD based on my view that China is serious about refocusing its economy and will be buying less iron ore and coal from Australia in the future.

Today’s highlights: During the European day, the highlight will be the German ZEW survey for February. Both indices are forecast to have risen and this could be the 4th consecutive rise in the indices. Following the surprisingly strong Q4 GDP growth rate, this will add to the evidence that the German economy is gaining momentum.

In the UK, the CPI for January is expected to have eased further. This is likely to confirm the comments in last Thursday’s inflation report that inflation may drop below zero in the coming months and remain close to zero for much of 2015. Therefore, the market reaction could be limited as a decline is already priced in somewhat following the inflation report.

In Sweden, we get the CPI for January. Last week, the Riksbank cut rates and introduced a mini QE despite the board’s belief that the underlying inflation has bottomed out. They also expressed readiness to do more to ensure that inflation rises towards the target. The CPI rate is expected to remain unchanged at -0.3% yoy, while the CPIF – the Bank’s favorite inflation measure – is expected to stay at +0.5% yoy. If the actual figure falls below expectations, this will prompt further action from the Riksbank and could weaken SEK further. Otherwise, we could see a short-lived strengthening of the currency.

In the US, the Empire State manufacturing PMI for February is expected to show that business conditions for NY manufactures is expected to increase a bit, while he NAHB housing market index also for February is expected to show a small improvement. These could boost USD.

We have one speaker on Tuesday’s agenda: Philadelphia Fed President Charles Plosser.

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