Its never over until the fat lady sings.

Greece still has to raise over 10 bln euros during April & May and the world’s bond investors know this only too well.

There is no point in them aggressively bidding up Greek debt and tightening its spread over German bunds whilst there is still an avalanche of supply to be absorbed.  The core problem with the EU & IMF agreeing to lend Greece money at Greek market interest rates if Greece fails to find willing buyers for her debt is that the EU/IMF proposal provides no incentive for the market to tighten Greece’s spreads over bunds (Greek 10-year bond yields traded above 7% in this first week of April 2010).   However during yesterday’s ECB press conference, Jean-Claude Trichet moved the goalposts and implied that “market interest rates” did not mean the cost of borrowing to Greece but the cost to each individual euro-zone member of raising their share of the money that would be lent to Greece.  If this is true then you can expect Greece to try to borrow money (effectively at a weighted average euro-area interest rate) from her fellow euro-zone members as soon as possible, i.e. this weekend.

In the absence of cheaper loans from fellow euro-zone members, it will only be when the markets sense that Greece has got over the crest of the hill (in terms of satisfying its funding requirements for 2010) that spreads over bunds will then start to tighten. In the meantime each week’s trading in Greek bonds is likely to follow the same pattern – big sell-off on Monday morning if there has been no bailout over the weekend then spreads squeeze tighter towards the end of the week in case a bailout emerges over the following weekend.

The EU and IMF are imminently going to be called upon by Greece to show the colour (and price!) of their money.  If & when the euro-zone members do get their act together, then the ending of the current uncertainty will cause a rally in the euro currency (and Greek debt spreads will snap tighter too).  It will all be announced over a weekend before the markets reopen on the Monday morning.

Its not over until the fat lady sings and Greece’s fat lady is currently warming up her voice in the wings and is about to step onto the stage.

Another EU summit passes by and still Greece has yet to get any joy from its fellow euro-zone members.  All Greece has been offered is a combination of loans from euro-zone members combined with loans from the IMF at market interest rates.  That is not what friends are for – they are supposed to lend you money cheaply when you are in a pickle.

Greece quite correctly points out that it is effectively adopting an IMF-style austerity program but without access to long-term loans at usual IMF-style interest rates of roughly 3.25%.  Instead Greece is having to pay more than 6% to borrow long-term money from government bond investors. Understandably Greece is not happy about this state of affairs.  Unfortunately the normal “3-pronged IMF cure” of a cheap loan, big devaluation and budget cuts will not work for Greece because Greece is locked into the Euro and cannot stimulate its economy to grow by devaluing its currency since the Drachma no longer exists.

The rest of the euro-zone cannot allow Greece to leave the Euro and revert to the Drachma (which would promptly collapse against the Euro).  This is because every euro-zone bank which owns Greek debt would suffer large losses on their Greek bonds.  The rest of Europe’s peripheral bond markets would also crater as investors headed for the safety of German bunds, so banks would also suffer losses on their other euro-zone debt assets which would precipitate another banking crisis in Europe. Bank runs would also take place in the weaker countries as savers moved deposits to banks located in core euro-zone countries. 

The ECB has also been forced to relax its collateral criteria so as to allow Greek government bonds to be eligible even if Greece has its credit rating downgraded in the future.  In the good old days the ECB would only lend against bonds rated A- or better but during the credit crunch the ECB decided to accept bonds rated as low as BBB-.  The ECB had planned to tighten the criteria back up at the end of 2010 but yesterday ECB President Jean-Claude Trichet confirmed that the ECB would carry on accepting BBB- bonds “beyond the end of 2010″.  It is notable that this commitment is deliberately open-ended.

The broader question is starting to arise :  Just what is the point of the Euro?

It serves Germany because the countries she exports to can no longer devalue their currencies to gain a competitive advantage.  However, as the current Greek crisis is now illustrating, when a euro-member country gets into trouble there are no benefits to euro-membership.  The markets charge you a hefty premium to borrow money and you can’t even get a cheap loan from your euro-mates to tide you over.  And you can’t devalue your currency to gain some relief either.  And you get lectured by your biggest sister that you wouldn’t be in such a mess if you had played by the rules all along.  Not much help when you are stuck.  Not much help either are the Growth & Stability Pact rules that say you get fined just when you are least able to pay (although no-one has yet been forced to pay).

The biggest draw of the Euro to aspiring members was the hope that everyone would be able to borrow at close to the interest rates that Germany borrows at.  This hope has now come seriously unstuck and needs patching back together again.  What is the point of joining a club which offers no benefits to members?

Over the past few weeks the Euro has formed a triple bottom at 1.3450 against the Dollar (the lows were on 19 Feb, 25 Feb and 2 Mar 2010).  Triple bottoms are rare in markets because most times a market prints a bottom, bounces off that bottom the first time it is tested but breaks through the support level if it is tested again (hence the old trading adage “Fade the first test but Go With the second test”).

The Euro now appears to have absorbed the selling pressure which has resulted from the problems Greece has been having in refinancing its borrowings.  Whilst the EU has pledged not to abandon Greece it has still not given any firm details on how it plans to offer support to Greece other than to encourage Greece to reduce its budget deficit towards 3% of GDP (as per the euro-zone’s Growth & Stability Pact).  Greece for its part “would like to borrow on the same terms” as other euro-zone members.  However the bond markets will demand a substantial premium to lend money to Greece until it proves it is actually carrying out the deficit-reduction measures it has promised in recent weeks. Yesterday Greece sold a €5 bln 10-year bond with a coupon of 6.25%, yielding roughly 312 bps over Bunds.

It has also become clearer over recent weeks that any support extended to Greece by the EU will not formally involve the ECB printing any money.  Euro-zone member governments have met public opposition to bailing out Greece with taxpayers’ money and the German press in particular has run stories opposing bailing out Greece if it means Greek public sector workers can still retire earlier than their German equivalents or even suggesting Greece sell off some of its uninhabited islands to raise some money.  Greece has in turn demanded the Germans return Greek gold which the Nazis allegedly stole during World War II…

Back to reality.  The receding prospect of the ECB printing money has helped the Euro to find support over recent weeks.  There is a subtle difference between the ECB printing money in order to buy Greek bonds and other euro-zone banks buying Greek bonds yielding circa 6% (with a strong nudge and guarantees from their respective governments) which they then use as collateral to borrow money from the ECB (at 1%).  The latter is simply good banking even if the net effect either way is the ECB finances loaning Greece money.  In the latter case the ECB can correctly claim that the risk lies not with it but with the banks.

Now that the Euro has found support at 1.3450 (until the market proves us wrong), the forex market can switch its attention to giving the Pound Sterling a good kicking in the run up to the May General Election.

Last Thursday the Fed raised its discount rate by 25 bps to 0.75%, as highlighted 8 days previously in Bernanke’s Exit Strategy speech on 10 Feb 2010.  As a result it now stands 50 bps above the upper limit of the current 0% – 0.25% range for the Fed Funds rate.  The Fed also took the opportunity to announce the return to the usual 1-day time limit for banks borrowing at the discount window (down from 30 days which was first put in place on 17 August 2007 - as the credit crunch first started to bite).  These actions indicate that the Fed is confident that the banks have now got their funding arrangements back into good order.

Despite the FT’s Lex column (20 Feb 2010) claiming that the discount rate is “almost irrelevant these days”, the Fed’s discount rate will become very important when the Fed eventually begins its next rate tightening cycle.  This is because the discount rate effectively represents the upper bound of the overnight interest rate during the period when the Fed is steadily raising rates.  The market doesn’t care about the lower boundary for overnight interest rates when rates are trending higher.

The Fed has also taken the precaution of giving itself the option of paying interest on money that US banks have placed on deposit at the 12 Federal Reserve Banks ($1.1 trillion is currently sitting on deposit).  In this way the Fed can force market interest rates higher should it prove difficult to get the Fed Funds rate moving in the desired direction (because of the $1.725 trillion which the Fed has thus far supplied to the markets via its Quantitative Easing efforts).

However any actual rise in US interest rates is still over the horizon and well out of sight.  The Fed has a so-called dual mandate to both contain inflation and promote employment (unlike the ECB which is only tasked with keeping inflation under control).  US unemployment is still very high at 9.7%  and, counter-intuitively, the unemployment rate may well rise further as a strengthening economy creates jobs.  Bernanke said in testimony this week that low interest rates “are supporting a nascent economic recovery”  and that “although the federal funds rate is likely to remain exceptionally low for an extended period, as the expansion matures, the Federal Reserve will at some point need to begin to tighten monetary conditions to prevent the development of inflationary pressures”.  In plain English, the Fed is going to wait and let the economy grow and create lots of jobs before risking its first rate rise. 

The Fed is simply getting its ducks in a row by preparing the ground for an eventual rate raising cycle.  It has to raise the discount rate first in order to create some additional headroom above the Fed Funds rate which it can then rise into.  By raising the discount rate well in advance of any hike in the Fed Funds rate, the Fed can now sit back and watch the market’s reaction, paying particular attention to 3-month Dollar Libor (the rate at which banks borrow Dollars from each other for a period of 3 months), which has been trading around 26 bps for many weeks now.

The Fed would like banks to borrow from each other and ideally to obtain funds from depositors rather than directly from the Fed itself at the discount window.  Historically the discount rate has been kept 100 bps above the Fed Funds rate and we can expect the Fed to aim for this level in future months.