Macro Weekly – What if Greece ….?

by: Han de Jong

Macro-Weekly_What-if-Greece_17-April-2015.pdf ()

Negotiations between Greece and its European partners are not going well. It would appear that equity markets are more affected than bond markets. Why is that the case and what will happen if negotiators throw in the towel?

Inexperience or irreconcilable?

The new Greek government was elected on a platform of protest against the course of economic policy in recent years. It was, therefore, never likely that they would quickly succumb to the pressure put on them by the European partners. We had thought, however, that a deal would be reachable. We reckoned that both side could compromise, offer the other side something worthwhile and being able to claim to have scored some point at the same time. So far that has not happened. Perhaps the willingness to compromise just isn’t there. Or perhaps neither side has enough room to make a deal. Or perhaps the new Greek government is simply too inexperienced and cannot make the switch from election rhetoric to serious policymaking.

Room and incentives to compromise

We thought that the Greek government would be willing to implement reform in areas that Europe would like and that previous Greek governments were unwilling to implement. Broadening the tax base in certain areas would be the most obvious, corruption perhaps another. On the European side, adjusting the austerity path a little would also seem doable. I obviously do not know enough details to assess whether or not a deal could be done.

It also seemed to us that the incentive to do a deal was strong on both sides. On the Greek side, the economy had started to improve at the margin. Risking renewed economic chaos seemed like a sufficiently unattractive prospect, more or less forcing the government to show enough flexibility. On the European side, a Greek default and/or departure by Greece from the eurozone seemed unattractive for several reasons. First, it would set an undesirable precedent. Second, Grexit would inevitably lead to a default and cost the holders of Greek debt great losses. A large chunk of Greek debt is now held by official creditors. Third, Grexit might lead to contagion in financial markets and be another setback for the European economy at large, the weaker countries in particular. Fourth, Grexit, a Greek default and the likely resulting economic, political and social chaos could lead to unpredictable and unwelcome developments in Greece’s foreign policy.

Might we be wrong?

Our assessment might be incorrect. As mentioned above, perhaps the Greek government feels it does not have any room for compromise or, more likely, they are too inexperienced to switch from election rhetoric to sound policymaking.

And perhaps we might also be misreading the other Europeans. It could be that they are unwilling to compromise for fear of encouraging Syriza-like movements in other countries. It could also be that the European partners feel that Grexit would be manageable. Financial markets are certainly behaving very different now from how they behaved in 2011/2012. For example, Portuguese government bonds fell sharply in 2011, pushing the 10yr yield to a high of over 15% early in 2012. Admitted, the yield has risen recently, but is below 2% at the time of writing. In the case of Spain, yields rose to 7.5% early 2012, they are now below 1.5%. Of course, there is a big buyer in the market now: the ECB. Without the ECB’s QE programme contagion to the other bond markets in Europe would, most likely, have been much more significant. But still…

It would seem that equity markets are more worried about Greece than the bond market or perhaps this is just a measure of the ECB’s shield of QE on the bond market. Against this background, any talk of an early end or slowing of the ECB’s QE programme is surely premature, although there are all sorts of other reasons as well. The ECB cannot announce an end or slowdown of its programme just two months into the process which is meant to last for some 18 months or so, or it will lose a lot of credibility.


All this remains speculation, interesting perhaps, but not necessarily very useful. We still think that reaching a suitable agreement remains in everybody’s interest, but at this stage one cannot rule out that a deal cannot be done. So it is worth our while to consider what might happen should Greece leave the euro.

I don’t think that Grexit is priced in by markets and if it were to happen, markets will respond strongly and negatively. But that is just the kneejerk reaction. Financial markets may soon consider that the ECB will continue to buy bonds and financial market participants will see a significant widening of spreads as a buying opportunity. The likely chaos is Greece will surely be a good reason for other countries not to follow that example. In fact, participants on financial markets will probably realise that with Greece gone, the eurozone will be more coherent and less prone to shocks. So my guess is that risky assets will soon find their footing again.

European economy going from strength to strength, US data remains mixed

European economic data continues to develop positively. Recently published data includes industrial production and car registrations. Industrial production was up 1.1% mom in February, though this series is volatile and the yoy growth rate was a mere 1.6%. Eurozone car registrations were up 13.2% yoy in March, the highest in five years. All this simply provides more evidence that the eurozone economy is recovering relatively briskly. We expect this to continue in the months and quarters ahead.

US data has been on the soft side since the turn of the year. We have long argued that weakness is caused by temporary factors. Most of these have run their course. As a result, we are impatiently waiting for an improvement in the incoming data. This week some signs of improvement, but the evidence remains underwhelming. March retail sales bounced back (+0.9% mom), so that is good. However, the rise fell short of expectations after three consecutive monthly declines. Small business confidence weakened in March. Industrial output also fell in March: -0.6% mom, although manufacturing production inched 0.1% higher mom. The yoy rate of overall industrial production fell to +2.1%, the slowest pace of growth in almost two years.

The first couple of regional business confidence indices for April were also released recently. The Empire State index, covering the New York Fed’s district, was weaker than expected, the Philly Fed index a touch better. The housing sector provided modestly better news as the NAHB confidence index improved a little.

On balance, we still believe that the pace of growth of the US economy will pick up during the year.

One of the wildcards in financial markets is whether or not and when the US Federal Reserve will start raising interest rates. In my opinion, this is highly unpredictable as the FOMC members appear very divided. Our view is that the first hike will happen in September. But if the economic data does not improve during the next couple of months, participants on financial markets may push out their expectations for the first Fed hike.

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