While talks continue on private sector contribution to a second bailout package for Greece, the market is already taking this into consideration.
John Kicklighter from DailyFX discusses this option, the upcoming ECB rate decision, the meaning of the end of QE2 and other fundamental questions:
JOHN KICKLIGHTER – Currency Strategist
Office: San Francisco
Bio: John Kicklighter is a currency strategist for FXCM in New York where he specializes in combining fundamental and technical analysis with money management. John authors a number of regular articles for DailyFX.com, ranging in topics from basic fundamental forecasts for the G10 economies and commodities to more complex subjects like the level of risk sentiment across the financial markets and the carry trade specifically. John has actively traded since he was a teenager. His experience ranges from spot currency, financial futures, commodities, stocks, and options on all of these instruments for his personal accounts. John graduated from the Zicklin School of Business at Baruch College in New York with a Bachelors degree in Finance and Investment.
1. Rating agencies are reluctant to put their stamp on the French private sector contribution scheme regarding Greece. Do you think that the crisis could return with full force if they declare “selective default”?
Just as the steps to approving and funding Greece’s fifth tranche of financial aid from its first bailout package (the confidence vote, the two budget votes, EU approval) were quickly priced in; so too is a selective default being accounted for. Deeming the country to be in default cannot be fully priced in however because the market simply hasn’t seen it happen in the construct of the European Union. Ultimately, the impact rests with what fallout the market expects. One of the more critical conditional changes would be a refusal by the ECB to accept Greek government debt as collateral for short-term loans – liquidity that is absolutely essential to keeping the country funded. That said, the central bank has bent the rules for Ireland before; and it would likely do so for Greece as well. As for the private-side implications of a default; debt holders could demand their principal back in mass but more than likely, officials would work a deal out to ensure capital does not completely abandon the economy. The bigger concern is the long-term implications to the Euro Zone’s overall structure.
2. QE2 is behind us and at least for now, QE3 is not in sight. Do you see the dollar gaining on this change? Or does the reinvesting scheme of matured assets going to weigh on the greenback?
There were two significant implications for the QE2 program: moral hazard (which leads to more reckless speculation) and lower US rates. A lower return on the benchmark US yields alongside a jump in risk appetite leverages the anti-dollar position the market takes. With the change in regime from an extremely loose policy to a neutral one, we disrupt confidence that capital gains will be fully supported going forward. So, while we have yet to actually withdrawal the stimulus from the system and theoretically unwind the government’s long position in the markets, investors are already preparing for that step. The reinvestment of principle on maturing assets essentially keeps the balance sheet at neutral and will not further lower rates. The moral hazard considerations are more pressing. Should the market start to withdrawal, it can start a larger shift in risk positioning and thereby boost the dollar.
3. The ECB is expected to raise the rates in the euro-zone. Do you think that Trichet will hint a longer pause now, given some weak economic figures? Or will he have a softer stance?
The ECB has fully set itself apart from its contemporaries. Where other central banks are either on hold or promoting a further expansive policy approach, the European authority continues to press forward on inflation fears despite the deteriorating situation in Greece and other periphery EU countries. The rate hike to 1.50 percent is fully priced in; but there is still heavy debate as to what tone the statement and President Trichet’s press conference will take. Given the insistence on preventing inflation from gaining a foothold and their lack of direct concern about the contagion for financial crisis, it is heavily expected that the ECB will maintain a hawkish bearing. The timing of this lean, however, is the critical factor. Given the issues in Greece and growing deficit issues in Spain and Ireland, they are unlikely to use the “strong vigilance” language that the market considers a signal that the next meeting will result in a hike.
4. Has the Swiss franc peaked out, as the Greek crisis is fading out?
The Swiss franc has garnered much of its strength from capital flowing out of the Euro Zone and into the banking economy in search of safety. Switzerland offers proximity and exposure to Europe without the direct fallout of a possible crisis. Through that relationship, an improvement in Greece’s situation is a hit to the value of the franc. The outlook for the Euro-area’s financial markets and the ‘periphery’ in specific are far from bright; but the immediate risk of collapse has been significantly reduced. That will be a significant barrier to the franc posting new record highs. Yet that isn’t the only consideration that could support the franc. A general collapse in risk appetite could leverage demand for the franc, dollar and yen across the board – yet such an expansive concern would not extend the Swiss currency any greater value than its counterparts.
5. China is showing some signs of slowdown. How do you see this affecting currencies?
Chinese officials are actively pumping the breaks on the country’s markets and thereby economy. Through the past few years, an accommodative policy stance akin to the approach the US took helped China charge ahead after a brief dip in its impressive growth rate. However, this support comes at a significant cost in that much of the growth the country has logged these past few years is through lending and construction specifically. Steps to curb this inflating bumble include limits on multiple mortgages, increased reserve ratios, rate hikes and the central government taking over regional debt obligations. These efforts are significant; but ultimately it won’t offset a slowdown nor would it reasonably prevent a market collapse. Considering the Chinese markets were the pinnacle of returns through the initial recovery phase back in 2009, its reversal can significantly undermine global confidence. Keep an eye on the prevalence on Chinese market concerns and their impact on risk appetite in benchmarks like the S&P 500.