Threats of exiting the eurozone could snowball

Outlook:

This week will get the usual chatter about the Dec 3 ECB meeting and the Dec 15-16 Fed meeting, with the Fed minutes on Wednesday. Traders will be girding their loins for next week’s Thanksgiving Day holiday (Thursday, Nov 26) that tradition-ally carries over to the next day. As for the new terrorist threat, we can expect fall-out in the directly af-fected sectors. The Swiss franc has already risen strongly against the euro. Oil rose despite the supply glut. Gold might recover more, although with US-tracking yields on the upswing, it might not. Reuters reports one-month euro/dollar implied volatility jumping almost 5% to 12%.

A key question is whether and how a new initiative against terrorists will cause growth to decelerate more than it has already. Two big effects are possible—a contraction in consumer spending and a drop in business capital spending in response. Off on the side but hardly marginal is the extent of the drop in Chinese growth. Major central banks have named the China factor in recent months, including the Fed, the ECB and the Bank of Japan. Today the news includes a drop in Chinese bank lending, with loans outstanding at the big four banks down by almost 50% m/m in Oct (¥35.7 trillion from ¥65.6 in Sept), according to Bloomberg. It’s the first drop in lending since 2009. Meanwhile, nonperforming loans are 1.59% of total credit, or 5.4% if you include “special mention” loans. This factor has been around for a while but this latest information puts it a little higher on the list of Frightening Things.

Barely noticed amid all the “news” about the Paris attacks is the announcement that the Finnish parlia-ment accepts a petition from citizens calling for a referendum on eurozone membership. Citizens gath-ered enough signatures (50,000) to get on the agenda. After checking signatures, still being collected, the legislature will design the referendum.

A Finnish member of the European Parliament is an informal sponsor, one Paavo Vayrynen, who says “Since 2008 the Swedish economy has grown by 8 percent, while ours has shrunk by 6 percent. Now is a good time to have a wider debate whether we should continue in the eurozone or not.” Reuters reports 64% of voters continue to favor membership, although this is down from 68% a year ago. Needless to say, the idea of Finland leaving the EMU is named "FIXIT.”

This is all a little crazy but you have to wonder if Fixit will revive Grexit and encourage Brexit. These threats of exiting the eurozone could snowball. On Friday, Canadian ratings agency DBRS af-firmed Portugal's investment grade status, pushing off a crisis since other agencies say it’s not invest-ment grade. All it will take is one push to reverse the decision and make Portuguese paper ineligible for the ECB buying program. Why would you want to belong to a club whose central bank will not buy your paper? Meanwhile, Catalonia is demanding a referendum (again), despite secession being forbid-den in the Spanish constitution. The Economist magazine is on the fence about whether anything real can come of it and that’s rare—usually The Economist has an opinion. Maybe all of Iberia can go its own way.

It may perhaps be too simplistic, but all this seems like a recipe for safe-haven flows. European yields are already a little higher, except for the Bund. The US yield curve may be falling back a little but the differential remains fully in its favor. The FT writes “German five-year debt no longer offers an income; instead, a negative yield of 0.11 per cent means investors are in effect paying the government to safe-guard their money. US Treasuries on Friday offered a 1.65 per cent annual yield for bonds maturing in 2020.

“The last time the gap between the bond yields of the two countries reached this size was July 1999, sev-en months after the launch of the European single currency. At the time a euro traded for as little as $1.03. On Friday a euro was worth $1.08, having fallen 11 per cent against the dollar this year.” The implication is two-headed: flows into Treasuries should suppress the yield, even while leaving it net in the dollar’s favor. But the yield differential has to stabilize. Nobody has said it yet, but some-body is sure to come up with the theory that the Fed may stay its hand again in December because of “global market turmoil.” This doesn’t destroy the policy divergence theory, but does shoot it in the foot. Stay tuned but stay square.