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The Euro Exit Threat Works in Greece

Last week we commented on the well timed appearance of French president Francois Hollande in the Greek media: he essentially said: you know guys, as a socialist I'm completely with you on this, but unfortunately, you can't really vote for the radical left. It's not me, you see, but there are others in the euro-group who would want to kick you out of the euro in case you elect SYRIZA. Sorry chaps, don't shoot me, I'm just the messenger. Of course he didn't put it exactly in that way – but it is what his message amounted to.

It seems to have worked.

Here is the distribution of seats in the new Greek parliament according to the latest official projections at the time of writing:

New Democracy (ND): 129 seats, SYRIZA: 71 seats, PASOK: 33 seats. The remaining 77 seats will be distributed between the smaller parties (far-right Golden Dawn, Stalinist KKE, the Democratic Left and the Independent Greeks). Mind that ND's 129 seats include the 50-seat bonus that is given to the party that garners the biggest percentage of the vote. In other words, the distribution of seats actually masks how close the race was – only a little over two percentage points lie between ND and SYRIZA in terms of the percentage of the vote they received. One of the reasons for ND's better showing was the decision to merge again with a small ND break-away party that didn't make it above the threshold to get seats in the May 6 election. However, the better part of its success this time around can no doubt be ascribed to the growing fear that a SYRIZA win would eventually lead to a euro exit by Greece.

With ND and PASOK garnering 162 seats together this time, the 'old guard' has a comfortable parliamentary majority.

So what to expect now? With regards to Greece and its agreements with the 'troika', we can expect that whatever funds are required to keep the Greek government running in the short term are likely to be released fairly quickly. However, it seems highly unlikely that it will be business as usual. Although ND leader Antonis Samaras has signed a pledge in February (addressed to Mario Draghi) that he would remain committed to the 'program', he left himself an out by noting that he intends to introduce modifications that "prioritize economic recovery."

Given the fact that SYRIZA has received only 2% fewer votes than ND, political pressure on the new government will be great, both from within and without parliament. The euro-group on the other hand is probably prepared to agree to concessions. Given that it is not yet known what exactly Samaras has in mind one should reserve judgment for now – but it is a good bet that he will try to accelerate the privatization program and roll back some of the tax increases.

As a German analyst remarked:

Holger Schmieding, chief economist at the German bank Berenberg and a former adviser to the IMF, said a coalition between New Democracy and Pasok would be a “relief” as it would reduce the risk of a Greek exit.

He believed Germany would now put aside doubts about Greece and agree to give it more time to meet fiscal targets, while the country would benefit from the growth initiative to be passed at the European Council summit on 28 and 29 June.

“If it shifts its emphasis from fiscal austerity to deregulation and other supply-side reforms, the Greek austerity and reform programme could finally work,” he said. “With an ND-Pasok coalition, Greece would have a 75% chance of still being in the euro by the end of 2012.

It is however also a good bet that whatever measures the new government introduces, it will find its actions greatly hindered by the inefficient bureaucratic apparatus of the Greek state. Moreover, in the medium to long term, another debt restructuring and/or a third bailout seem likely. The main reason for not expecting a second debt restructuring in the near term is that it would impact the official lenders, i.e., the troika (IMF, ECB and EU).

It should be clear that Greece is in no less a dire position in terms of its indebtedness as before. On the other hand, there are in fact subtle improvements in economic data that have not yet made it into the most visible statistics, such as a narrowing of the trade deficit (excluding oil) and the government's primary deficit. One wonders why anyone would want to become prime minister of Greece at this time, but maybe Samaras actually gets lucky by getting the job near the nadir of the economic contraction.

The G-20 Meeting and Financial Markets

The initial reaction of stock markets in Asia to the election result was as one might expect quite positive. Not only was the Greek election well received, but rumors were making the rounds that the G-20 meeting may result in a beefing up of the IMF's bailout chest.

However, even a bigger IMF bailout capacity will not be enough to bail out nations like Spain and Italy. Moreover, it seems there is actually still a great number of obstacles in the way of this plan – and a bigger IMF war chest may not be used to directly benefit the euro area anyway.

The optimistic mood was buoyed by growing expectations that the G20 would on Tuesday unveil a greater than expected increase to the IMF’s firepower beyond the $430 billion promised in April.

G20 summit host Felipe Calderon told reporters in Los Cabos: “I estimate that there will be a larger capitalization than the pre-accord reached in Washington, which will be finalized here, but I don’t want to speculate by how much.”

The decision is likely to be seen by markets as a sign that the world’s leading nations are prepared to provide the firepower to kill the threat of euro contagion. “This is not a trivial sum,” said Andrew Kenningham, an analyst at Capital Economics, who said the agreement would double the Fund’s usable resources to around $800bn (€650bn).

“However, it would not be enough to finance bail-outs for both Spain and Italy unless the IMF were willing to shoulder a much larger share of the burden than it has in previous bail-outs – something which the IMF’s key shareholders would not sanction,” he said. “What’s more, it is clear that the euro-zone crisis cannot be resolved by bail-outs alone, however large the sums involved.”

Calderon confirmed that the United States would not be taking part and the contribution of the key BRICS economies of Brazil, Russia, India and China, is still unknown.

Brazil has sought to link the refinancing with the agreement to boost the voting power of emerging markets on the IMF, which has still not been approved by enough members two years after it was agreed.

Japan, which was one of the strongest supporters of the IMF recapitalization with a $60 billion pledge, warned that it wanted to see greater voting powers going to countries that had taken part in the refinancing in the next round of IMF voting reform. Japan’s vice finance minister for international affairs Takehiko Nakao said he believed voting reform should “take into consideration” countries contributions.

“We are starting discussions about the quota formula and when we think about this our idea is that the quota allocation should take into consideration the contribution to the IMF including this kind of lending,” he said.

(emphasis added)

The latter point is not without consequence; the US don't want to contribute to the IMF recapitalization for domestic political reasons, but surely the US want to retain their veto power. Current IMF regulations require an 85% majority vote for major decisions. The US share of 16.75% (see all IMF quotas here) allows it to veto such decisions. Neither is Europe very eager to relinquish any of its voting power. Funny enough, a previous attempt to alter the IMF's quotas according to new contributions would actually have preserved the US veto – nonetheless, nothing has actually happened in terms of implementation.

As pointed out in a recent Bloomberg article:

At April’s meeting of the IMF, donors from Japan, South Korea, India, Saudi Arabia, and China, among others, agreed to lend the fund $430 billion to help it contain the euro crisis. The organization has resorted to borrowing this money rather than increasing quota contributions—its equivalent of shares—for the simple reason that quotas are the basis for voting power on its board. Emerging countries and oil producers have the cash to commit and want to play a greater role in the IMF, but Europe and the U.S. don’t want to relinquish their voting shares.

This unwillingness to give others more seats at the table is all the more stunning when you consider that the U.S. and Europe have previously pledged to do so. At its 2010 summit in Seoul, the G-20 agreed to undertake a “comprehensive review” of the IMF’s quota formula—the system that decides voting shares in the institution. Under current rules, the IMF assigns each member country a shareholding based in part on that country’s power in the global economy. The size of the quota dictates the country’s share of votes on the fund’s board. The U.S. has a 16.75 percent voting share, giving it veto power over major IMF decisions, which require a supermajority of 85 percent.

The Seoul reforms called for doubling the IMF’s resources and shifting more of the funding burden to emerging powers such as Brazil, Russia, India, and China; that would translate into greater voting powers for the BRICs as well. The new arrangement would not require any increase in financing from the U.S. (resources that it has already lent the IMF would be converted into quota shares) and would still leave it with veto power. And yet the Obama administration hasn’t even submitted the legislation to Congress.

The result is the perpetuation of a system that is laughably anachronistic. Under the current arrangement, the European Union, with about 7 percent of the world population and about 20 percent of the world’s GDP, accounts for one-third of the IMF quota and therefore controls an equal proportion of seats on the fund’s board. Even if the reforms outlined in Seoul are implemented, voting shares will remain disproportionately tilted toward the U.S. and Europe. The BRICs as a whole will have 14 percent of the voting power on the fund’s board, compared with 29 percent for the EU—even though, according to measures of GDP that account for being able to buy more for your money in developing countries, the BRIC economies are considerably larger.

The developed world’s lame-ostrich strategy of being too weak to commit additional resources, but too fearful to give up votes, can last only so long.

As far as we're concerned all of this matters little; what the world needs is honest money and free banking, with strict enforcement of property rights (i.e., no more fractional reserve banking). Then it would certainly no longer require any supranational 'bailout' bureaucracies like the IMF. Obviously sound money is not yet on the menu – that will have to wait for the current system's involuntary but inevitable demise, and even then it is by no means certain that the replacement will be a free market type system.

The main reason for discussing the above is to make the point that it won't be so easy to implement the IMF recapitalization on which the financial markets are apparently pinning their latest hopes. The experience with G-20 summits (and all the other summits that have taken place with great fanfare in recent years) is that they achieve nothing tangible. Usually they end with the publication of a vaguely worded communique that is long on promises and short on details. This is actually a good thing. The less these dunderheads manage to actually do, the less harm is likely to befall us.

Meanwhile, it seems likely at the moment that the recent retracement rally in stocks and other 'risk assets' will live on for a little while longer. However, the fact that the Greek threat has been temporarily removed will actually make it less likely that fresh monetary pumping measures will be instituted in the near future. Furthermore it does not do much for the problems of Spain and Italy – at best the crisis can be expected to experience another brief pause.

Note in this context that the initial decline from the early April high in the S&P 500 index – a peak that was accompanied by a plethora of bearish divergences and widespread bullish unanimity as we pointed out shortly before it was put in – was followed by a five wave decline, i.e., an impulse wave. This means that the high probability expectation should be that the rebound will at most retrace 100% (but likely less) of the initial decline and that the primary trend has once again turned down.

This view would obviously be invalidated if the market manages to make a new closing high – the point is merely that a change in the primary trend from up to down has become the high probability expectation – it is not an apodictic certainty.

The recent short-term low was accompanied by the type of RSI divergence typically seen at lows in all time frames and as we have mentioned last week, very high net speculative short positions in euro and Australian dollar futures actually indicate that the rebound has a fairly good chance of extending further.

(click to enlarge)

The S&P 500 (NYSEARCA:SPY) with a wave count of the initial decline from the high. This should now ideally be followed by a rebound that retraces no more than the initial decline to produce wave 2. Any decline beginning from a lower high could be strong indication that the biggest portion of the downtrend (wave 3) lies directly ahead - click chart for better resolution.

Below is a recently updated version of two charts by our friend B.C., which we have shown before. The first chart compares the ECRI WLI data of several past recession periods with the current data beginning in 2010. The second chart shows the annual rate of change comparison of the WLI during past recessions with current data beginning in 2011.

(Click charts to enlarge)

(click to enlarge)

ECRI's WLI during past recessions compared with the WLI data 2010 - today

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Annual rate of change of the WLI during past recessions and the period 2011 to today

As the ECRI (Economic Cycle Research Institute) keeps reminding us, it still predicts that a recession will begin in 2012. The data ECRI employs in making the prediction go well beyond the WLI as it were. We're of course not certain that this particular forecast will pan out, but we would accord it a high probability as well, due to the economic imbalances generated by the intensive monetary pumping of recent years which we have previously discussed. Recessions are generally not good for the performance of stocks and commodities, so there are also good fundamental reasons to expect the above wave count to turn out to be correct.

A standard fibonacci grid applied to the most recent high and low shows that the SPX has retraced exactly 50% of the preceding decline as of Friday's close. The 61.8% retracement is at approximately the 1363 level, but a 78% or 100% retracement would also be within the guidelines for a wave 2 retracement.

(click to enlarge)

So far, the SPX has retraced 50% of its decline from early April to early June

It is noteworthy that the Euro-Stoxx Index, while also sporting a five wave decline from the most recent high, has so far only retraced a far smaller portion of it. This makes it very likely that the next peak will once again be marked by a divergence between US and European stocks, similar to what was seen on occasion of the March/April peak.

(click to enlarge)

The decline in the Euro-Stoxx index started from a lower high, was deeper and has only managed a comparatively much smaller rebound so far – which is very similar to the sequence that began in July of 2011

Addendum: Wildfire Goes Away, Eurogroup Reacts

In a symbolic event, a wildfire raging near Athens receded on Sunday. Meanwhile, the euro-group reacted to the election with this statement (pdf).

A snippet:

The Eurogroup therefore looks forward to the swift formation of a new Greek government that will take ownership of the adjustment programme to which Greece and the Eurogroup earlier this year committed themselves.

Taking ownership of exactly the same program will probably result in losing the next election and having to battle violent demonstrators in the streets.

As noted above, it likely won't be business as usual between Greece and the 'troika', even though the 'pro bailout' parties are able to form a government.


Addendum 2: Still No Joy in Spanish Bonds

Meanwhile, in early European trading, Spain's 10-year yield spiked up by another 25 basis points to a new high of 7.12%. We can therefore state with absolute certainty that Spain's economy minister Louis de Guindos recently misdiagnosed Spain's main problem. He had asserted about two weeks ago that Spain's biggest problem was Greece. Evidently this is not the case.