USD strength expected as Grexit fears and Fed rate hike looms

The Day So Far

Turmoil across financial markets this morning, with the Dax gapping down overnight 5% lower, trading at one point below the 11,000 handle. Stoxx was similarly punished, and US equities didn’t escape unscathed, with S&P futures hitting 2050, its lowest level since the early May sell-off. This catalyst, as with much of the recent action, was Greece, new flow over the weekend points towards a first exit from the European monetary union by one of its earliest members. There was drama after the markets closed on Friday night when Tsipras called for a referendum for the Greek public to decide whether to accept the creditors’ latest offer. This was ratified over the weekend by the Greek Parliament, and the referendum is scheduled to take place on the 5th July, next Sunday. The other major event which occurred yesterday was the ECB’s decision to limit their ELA assistance to the Greek banking sector, essentially leaving the ‘life support machine’ on but without increasing the lending ceiling with which the Greek banks have used to match depositor outflows in recent weeks. The threat of a withdrawal of all financial support to the Greek banks probably remains the trump card for the creditors in their fight for supremacy over the Greek government. So, a frantic start to the week in equities, and also in currencies, with the euro smashed 200 points lower below the 1.10 handle and fixed income nicely bid, with the Bund up above the 152 handle.

Elsewhere , the wheels continued to come off the Chinese equity market, with the Shanghai ‘limit down’ for the day, and the index entering bear market phase (typically characterised by a 20% fall).

The Afternoon View

This afternoon is a tricky session to gauge, with clear risk-off permeating the markets now, but potential for some retracements this afternoon. Despite the precarious nature of Greece’s situation, they do remain in the euro and have not yet defaulted, and time is not quite up until they have to make the whole June Eur1.5bn payment to the IMF (due tomorrow).. However, we advise going with classic risk-off moves today , as investors finally begin to price in the ramifications of a ‘Grexit’. The way markets traded last week, as discussed at the time, reflected some complacency that a deal would be reached ahead of Tuesday’s payment, but now this is clearly in doubt and it will be fascinating to see how markets respond to a Greek default. Contagion as witnessed in 2010 and 2011 is unlikely given the ECB’s overt support , and look for emergency liquidity ‘firefighting’ measures if the worst comes to the worst. Also, aside from the financial pain experienced by the public sector creditors in the event of default (the EFSF, ECB and IMF will be most of the brunt of losses), the Greek economy is a tiny fraction of the European economy as a whole so the fallout should be swift but could also be violent. Therefore, we are looking for shorts in equities, long t notes and dollar strength, not just based on the Grexit fears, but also as markets fret about the Fed rate hike looming large on the horizon.