Greece's day of reckoning is only the start
Another week and another Greek deadline has come and gone. But EU leaders have vowed yet again that a final decision will come on Monday, and this time they really, really mean it. Except that they're still working over the weekend on the final details of the accord, so yet another impasse or breakdown could materialize. But we'll give them the benefit of the doubt and expect that EU finance ministers will approve the second bailout, likely requiring some form of escrow account. Such an arrangement will set the stage for further showdowns in the months ahead, as Greece will repeatedly need to meet deficit reduction targets to obtain subsequent aid disbursements, and their track record there is not good.
While we think the Eurogroup will approve the next Greek bailout on Monday, we can't rule out last minute hang-ups on key issues, potentially pushing the decision into the March 1-2 EU Summit. Eurogroup officials will meet informally on Sunday night and begin the formal session around 1430GMT on Monday. If they do approve the bailout, we would look for risk assets (stocks and commodities) and EUR to make yet another minor relief rally. Clearly, if they don't approve of the aid, we would expect risk markets and EUR to come off relatively hard, as the risk of a disorderly default would be intensified. The ultimate deadline to keep in mind is the March 20 maturity of EUR 14.5 bio in Greek government debt.
While much attention has been focused on the question of whether Greece will or won't receive the second bailout package and avoid a default, we think the bigger risks are from the fallout over the Greek debt swap deal with private sector investors (PSI). In this situation, we are looking at many so-called 'known unknowns.' This stems from the credit default swaps on Greek government debt and whether they will be triggered, which financial firms are on the hook for them, and for how much.
The current terms of the PSI negotiations strongly suggest that a 'credit event' will be declared, but ultimately that's up to a committee of ISDA (International Swaps Dealers Association, the CDS and derivatives industry self-regulatory body) to determine. However, reports circulating on Friday indicated that some private creditors were already preparing legal action against the Greek government over the amount of losses they're being forced to swallow. Friday also saw the Greek government announce that it's preparing a 'collective action clause' law (CAC) for outstanding Greek government debt. CAC's permit a super-majority of bond holders to alter the terms of existing bonds, making the debt swap deal a non-voluntary affair. Various credit rating agencies have indicated imposition of CAC's would constitute a 'credit event', likely triggering CDS payouts. This brings us back to the known unknowns of which financial firms are liable and for how much, potentially sparking global financial sector upheaval as investors retreat to safe havens. And then there are the 'unknown unknowns,' where we don't know what we don't know. For many, this is the bigger risk out there, potentially making the fallout from the Greek debt deal make Lehman look like a walk in the park.
Overall, we think a resolution to the Greek rescue drama next week may simply be the start of a larger, messier drama involving previously unentangled financial institutions globally. At the minimum, we would expect a deal on Greece to offer only a short-lived respite, before markets begin to question anew the sustainability of Greece over the longer haul.
Further JPY-weakness may be in store
The JPY has undergone a distinct adjustment lower versus other major currencies over the past week following the BOJ's decision to initiate another round of QE and establish an inflation target of +1.0% (latest CPI was -0.3%), suggesting more QE will be needed in the future. Together with Japan's trade surplus evaporating into a deficit (January trade data due out on Monday morning in Tokyo; adjusted trade deficit of -JPY 850 bio expected), we think there is scope for further JPY weakness in the weeks ahead. Anecdotal reports also suggest Japanese investors started to actively reduce their portfolio hedges, leading them to buy foreign FX and sell JPY, adding yet another flow to JPY-selling pressure.
USD/JPY and many of the JPY-crosses have reached 3-month highs and are testing key resistance levels, such as USD/JPY 79.50/80.00 and EUR/JPY 104.50/105.00. While we think there is further upside in store, we would avoid getting long at these levels and prefer to wait for a pullback to pursue long entries (selling JPY), ideally around 78.00/50 in USD/JPY and 102.70/103.20 in EUR/JPY. Breaks above the resistance zones mentioned above may see JPY-pairs move directly higher in this adjustment. Potential turmoil emanating from Europe next week could provide the desired pullback, if investors turn back to the JPY and the USD on safe haven demand.
Light US data may see risk rally stall
Next week sees the US President's Day holiday on Monday where US stock and futures markets will be closed. The rest of the week sees relatively minor US economic data (existing/new home sales; weekly jobless claims) only late in the week. We note this because the risk rally currently underway has been extremely tentative and seems to require frequent injections of better-than-expected news and data to keep going. More positive US data reports of late have been a primary source of that optimism, but with minimal data out of the US next week, that medicine may be in short supply. Together with potential disappointment or outright disarray out of Europe, we would not be surprised to see a more negative correction to risk assets and a further bounce for the USD.