Not the Result Markets Had Been Assuming

July 8, 2015

In this age of uncertainty, the baseline scenarios adopted by investment houses on key assumptions invariably assume growth-promoting outcomes.  Marketing considerations are the driver behind this forecasting bias.  Optimism sells, while pessimism does not.  Also, modeling foreign exchange and other financial market trends  is far more manageable with happy endings where unanticipated shocks occur from time to time but are self-limiting and ultimately reversible at least in part.

The Greek debt crisis exemplifies the above bias.  Alas, the differences remain truly irreconcilable, and time is running out.  Greece’s depression has been more severe than what the United States experienced in 1929-33.  To imagine Greece adopting creditor-mandated austerity at this point is to believe that American voters might have considered four more years of Hoover.  The presumption that the Greek government has no alternative but to take its medicine is based on the belief that abandoning the common currency would be even more catastrophic, but many of the costs of Grexit are already happening to Greece.  Last Sunday’s landslide rejection of austerity via referendum makes it now not only economically very painful to acquiesce to more austerity but also politically untouchable.  If a compromise is to be reached at the last minute, the main concessions will need to come from the rest of the eurozone.  But they are convinced that the danger of contagion after Grexit has been cauterized and equally fear that capitulating to the Tsipras government will create a bad precedent for other EMU members that may in the future run afoul of the rules.  Hence, my conclusion that the differences between Greece and its creditors are now beyond repair, or even a fashioning of more more kick of the can down the road.

It is messy to contemplate what happens to the euro and other currencies if Greece leaves the group.  In one sense, it’s a little like sterling leaving the old ERM (Exchange Rate Mechanism or joint float) in mid-September 1992.  The pound and British interest rates plunged, but the mark also lost 9% against the dollar over the remaining 3-1/2 months of that year.  The euro chain would be rid of its weakest link, but the ensuing chaos emanating from Greece would be an economic and humanitarian sore too close for the rest of the region to ignore.  The leftist Tsipras government will be desperate for any kind of external support, and Russia will all too happy to comply.  When eastern Europe threw out communism 25 years ago, governments there turned westward, some joining Nato and the EU.  A shift in Greece’s allegiance away from these affiliations would constitute the long-awaited counter-weight that Russian President Putin has been seeking with even more symbolic significance than the pieces taken back from Ukraine.

Greece is not the only gigantic uncertainty on the financial market playing field.  Chinese share prices have been plunging amid mounting concern that Beijing officials will be unable to manage China’s economic development as well as they’ve done up to this point.  Chinese real GDP growth of 7.4% in 2014 was the lowest since 1990, and a slowdown from 11.8% in the year to 1Q10 to 7.0% in the year to 1Q15 is like going from nearly 5% to zero. It’s a very big deal, and the momentum is still downward. 

Since the Great Recession, long-held myths that wealth can be protected by diversifying across different classes of assets such as bonds, commodities, real estate and stocks and by also diversifying on geographical grounds have been tested by mounting evidence about the interdependent web of all markets.  When like today the Greek talks take a turn for the worse and China’s market falls sharply in spite of policy efforts to halt speculative selling, U.S. markets were hit hard, too.  It remains therefore to be seen how comfortable Fed officials will feel about raising interest rates later this year and in 2016.  It does seem that the FOMC is very anxious not to delay the first move, and it almost certainly will be by 25 basis points.  What’s at greater stake is the path of ensuing increases and the timing and peak of the tightening cycle.  With these constraints, Fed tightening may generate less incremental demand for the dollar than what ordinarily would seem likely at a time of rising Fed rates but continuing ECB and BOJ quantitative stimulus.

The world is not unfolding in a way that investors want.  Implications for the dollar’s main relationships are ambiguous.  Some currencies are being allowed to seek out whatever level best clears market demand and supply.  In other cases, officials have been outspoken about the directionality they favor for their currencies.  It may turn out in this age of heightened uncertainty that the best currency bets are the ones taking their cue from the rhetoric of officials.

Copyright 2015, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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