German Chancellor Angela Merkel has extracted the necessary promises from Greece that they will be good in future and properly respect the rules of the euro-zone’s Growth & Stability Pact (i.e. bring their budget deficit back down to less than 3% of GDP).  Whilst the bigger & stronger countries within the euro haven’t quite worked out all the details yet, Germany has sent a “clear political signal” to Greece and the wider financial markets that (with the independent IMF checking that Greece keeps to its promises) they will support Greece if it cannot borrow enough money at a reasonable rate from government bond investors.

This is a pivotal moment in the course of the euro-zone and its monetary union.  Germany is the key player and can make-or-break any smaller country which gets into trouble raising money from government bond investors.  Bringing in an independent outside entity, such as the IMF, to play policeman will allow countries to sell difficult tax-raising budgets to their voters.  Having given up the Drachma for the Euro, Greece no longer has a central bank which can print money to finance its deficit and/or devalue its currency (both of which are exactly what the UK has done over the last year or so).

An important precedent has thus been set and Germany has used this Greek crisis to get what it wants, namely the peripheral nations are going to have to play by the rules from now on or they will get hung out to dry. This is going to be tough on the economies of the peripheral countries and their growth is going to suffer as they shrink their budget deficits back down from 10%+ to below 3% of GDP over the next 3 to 5 years. 

However the message to players in the government bond markets is clear – the great convergence trade (which last took place in the run-up to the euro’s birth on 1st Jan 1999) is now back on.  Spreads over bunds have now tacked back onto a tightening trend and, whilst they will not converge all the way down to 20bps or so, it is going to be worthwhile buying the dips every time the yield spreads over bunds widen back out again.

The Euro continues to trend lower against the Dollar as the recent turmoil in Greece’s government bond markets has started to spread to Portugal and Spain too.  Events are starting to spiral out of control, evidenced by 10-year Greek bond yields rising from below 6% to more than 7% over the past few weeks (inflicting losses on the buyers of Greece’s €8 bln 6.2% 2015 bond which was issued on 25th Jan 2010).

Eight billion euros is only the first instalment on the €53 bln which Greece needs to raise in 2010 and it is this impending refinancing need which will bring matters to a head sooner rather then later.  Greece is now in the market’s spotlight and is really in trouble because this particular bond market storm is not going to simply blow itself out and go away.

The panic in Greece’s bond market is going to have to get a whole lot worse and this will eventually force the rest of the Euro-zone to act.  The markets don’t believe that the Greek government will be able to impose austerity measures on the Greek public (public demonstrations and strikes have already started).  ECB President Trichet has been quoted as saying ”We expect and we are confident that the Greek government will take all the decisions that will permit them to reach their goal”.  What else can he say?  If he told the truth and said they were stuck like pigs in a poke and the squealing would have to get a whole lot louder before they get bailed out, then Greece’s bond market collapse would intensify and yields would rise even more rapidly.

The endgame is fast approaching and it will not include the IMF lending money.  The bigger and more stable members of the Euro cannot allow Greece to be rescued by the IMF and thereby show the whole world that Euro-land can’t manage its own internal affairs.  Whatever tax-raising promises get made by the Greek government are irrelevant (as only time will tell whether they can actually impose the promised tax rises on the Greek public) as Greece does not have the luxury of time on its side.  

The end of this crisis will be signalled by a large amount of money being loaned to Greece by any or all of the following : Germany, France and the ECB.  Watch out for a classic euro-zone “enhanced credit support” fudge whereby the ECB suddenly decides to embark upon Quantitative Easing which involves the purchase of large quantities of euro-zone members’ government bonds.  The EU itself cannot extend a long-term loan because it also represents non-eurozone members.

Markets are going to become even more disorderly before this panic is over but the bigger picture is that this is a panic in the PIIGS’ government bond markets and, whilst it may impact other markets in the short-term, the resolution of the crisis will provide a buying opportunity across multiple asset classes.  The Euro will keep trending lower against the Dollar (and Sterling to a lesser extent) until the crisis is resolved because the resolution may involve the ECB printing a few hundred billion euros.  The ECB will then have joined the other major central banks in the Race to the Bottom and, as usual, the ECB will once again have proved itself to be the slowest to act.

Do the last three weeks of US Dollar strength represent the start of a bigger upswing in the fortunes of the Dollar?

We have just seen the Dollar close higher for three consecutive weeks, as measured by the Dollar Index. This hasn’t happened since the Dollar topped out in March 2009 (as global stockmarkets simultaneously bottomed).  We last saw a strong Dollar rally during July – November 2008 as a mad scramble for dollars took place – see “Get me a Printing Press“.

There is also a confluence of fundamental factors coming together at the moment which together provide a more solid basis for a sustainable rally in the Dollar.  The Fed is scheduled to end its current bout of $1.75 trillion QE bond purchases by the end of Q1 2010.  In addition this week’s FOMC statement highlighted that most of the Fed’s special liquidity facilities will expire on 1 Feb 2010 and that the Fed will also be closing its Dollar swap arrangements with other central banks by 1 Feb 2010 too.  The net effect is that the Fed will be shutting down three different ways in which it has been supplying Dollars to the markets.

For its part, the Euro has been impacted by the recent turmoil seen in Greece’s government bond markets and the currency markets have once again taken note that the Euro is not the same thing as a Deutschmark and it can be undermined to a certain extent by the PIIGS membership.  If Greece really got into trouble, there is no way that the other, more stable, members of the Euro would allow Greece to be rescued by the IMF (and thereby show to the whole world that Euro-land couldn’t manage its own internal affairs).

The Japanese Central Bank is also offering 10 trillion Yen in 90-day money into its money market, although the Japanese have historically been quite timid with their Quantitative Easing and this measure runs true to form in being less aggressive than, say, purchasing long-term government bonds.

Finally the US employment report for November 2009 showed both the unemployment rate falling and weekly hours worked rising.  This implies stronger US GDP (70% of which is consumer spending) which has also served to boost the Dollar.

Neither is the Fed itself going to stand in the way of a Dollar rally.  Now that a tentative recovery has been established in the States and GDP is growing again, the Fed does not need to manage the Dollar lower from here but it would surely be happy to see a combination of the Dollar rallying and lower oil prices (which would serve to keep inflation under control and lower gasoline prices would put more money into consumers pockets).

A Dollar rally at this stage is not negative for US stockmarkets because consumers having more money to spend means that companies can grow their top-line sales and generate higher profits.  These higher profits will help to keep the stockmarket rallying into 2010 (the Dow has been in a 10,200-10,500 range for the last 5 weeks, consolidating now that it has recovered half of its Oct 2007 – March 2009 losses).

All this currency printing (Dollars, Sterling, Yen & Swiss Francs) by central banks as they engage in their various forms of quantitative easing is leading to a depreciation of their currencies against real assets. This is being disguised by talk of currencies engaging in competitive devaluations against one another but eventually it will show up in the price of real assets increasing as measured against these fiat currencies. By real assets we are talking about Oil, Real Estate, Gold and Equities (the first three of which God ain’t making any more & equities are a claim on nominal GDP). Government bonds are being propped up by heavy central bank buying and may well remain expensive for years (there is no point in fighting concerted central bank buying of government bonds – John Maynard Keynes pointed out that “markets can stay irrational for longer than speculators can stay solvent”). Don’t read too much into “failed auctions” of Government bonds such as happened this week in Gilts – this is a brave new world and market participants are still feeling their way towards what they should be paying the DMO for 40-year gilts when the BoE is busy buying 5- to 20-year paper. The head of the DMO (whose job it is to sell gilts as expensively as possible) should have kept quiet rather than allow himself to be quoted as saying “Yields at these levels are not all that attractive”. However the general idea to issue longer-dated gilts than the BoE is buying back is surely the correct strategy for the DMO to execute whilst gilt yields are this low, even if the execution is proving a little untidy at times.
As usual the ECB is the slowest of the Western central banks to act – they have yet to commence quantitative easing but the central bankers of Portugal, Ireland, Italy, Greece & Spain (collectively called the PIIGS) must be praying for the ECB to start buying government bonds soon as there are few other buyers of PIIGS bonds at the moment and they have lots to sell. The ECB has a practical problem to overcome if & when it decides to implement quantitative easing, namely which eurozone countries does it choose to favour by buying their government bonds? If the ECB wishes to ease tight credit conditions then it should logically buy the PIIGS’ bonds and squeeze their yields back down towards German levels (the great “convergence trade” would be back on with a vengence), in the process helping to allay market fears about any of the PIIGS leaving the Euro. Once could reasonably expect squealing from any eurozone country whose bonds were not purchased by the ECB. Not a pretty problem for the ECB to overcome whilst other central banks already have the printing presses rolling flat out.

Post-Script (23 April 2009) :  One possible way for the ECB to execute Quantitative Easing would be for the ECB to spend its money by buying equal amounts of each eurozone member countries’ government bonds.  In this way the policy could be sold as being “fair” to all whilst having the desired side-effect of a greater impact on the PIIGS due to the smaller size of their economies relative to Germany, France, et al.