Markets seeking hints about Fed dropping "patience" from today's FOMC Minutes

Outlook:

Today we get US industrial production, Jan housing starts, and PPI. The important nugget is the minutes of the last BoE and Fed minutes. Note that the central bank minutes will be seen in the context of wage recovery in the UK, green shoots in Europe and if not green ones in Japan, at least not withered and dying ones. If the Fed is willing to continue to disregard deflationary tendencies, we are almost set to go.

We won’t get Fed answers today but everyone will be seeking news or hints about dropping “patience.” We will also get a token reference or two to external events like Greece, but realistically, this is none of the Fed’s business in the absence of contagion, and doesn’t rise to the level of requiring Mr. Fishers’ committee to say or do anything. We say events in Europe will have no influence at all on the Fed’s decision-making.

We are impressed by an opinion piece by Mark Gilbert in Bloomberg. Gilbert asks why Germany is being so uncompromising on a deal for Greece? Yesterday we played up the sacred contract idea, but Gilbert says (1) Germany may prefer Grexit, as suggested to great publicity by Der Speigel in January.

“Officials in Berlin and Brussels no longer subscribe to the so-called 'domino theory,' which held that a Greek collapse would be followed by others. It has been replaced by the `chain theory,' which holds that the entire chain would become stronger were its weakest link to be eliminated.” And indeed we are not getting contagion. Yields and equity markets in the southern tier are stable. It’s not at all obvious that the euro would fall if Grexit occurs.

Secondly, “Germany would sacrifice Greece to keep everybody else in line.” This means the populist Podemos party in Spain and whatever fringe parties in Italy and France might get up to. And finally, Germany doesn’t give a hoot about Varoufakis’ much-touted expertise in game theory. As we wrote the other day, every 4-year old knows the crazy kid routine. Like Keynes’ observation that the market can stay irrational longer than you can stay solvent, Germany can stay stubborn longer than Greece can pay its bills.

We find these arguments compelling, or at least the first two. Others do, too. Gilbert cites Commerzbank putting the odds of Grexit at 50%. The question now is whether Mssrs. Tsipras and Varoufakis find the arguments compelling. Never mind that none of the eurozone treaties include measures for a country exiting.

With every borderline state lining up at the door to be let into the EU and/or eurozone, it looks weird for Greece to be turning its back on EMU. To be accurate, Greek citizens overwhelmingly do not want to leave the eurozone—it’s the new government that is risking Grexit. So, if the Greeks do not back down and bow to Berlin and Frankfurt, should we expect a vote of no confidence and another election? And if there is a new government that wants to get back in, will the rest of the EMU allow it? Logically, the answer is no, at least not right away. Greece would have to prove it is meeting the criteria, like Croatia. Croatia, for heaven’s sake.

The convergence criteria feature prominently the “Soundness and sustainability of public finances, through limits on government borrowing and national debt to avoid excessive deficit.” Well, Greece has proven repeatedly that it does not have sound and sustainable public finances.

At the same time, we are coming to a better understanding of the Greek position. One Quartz writer has an interesting metaphor: “Even German finance minister Wolfgang Schäuble told German voters in 2013 that another Greek bailout was inevitable. So insisting that Greece endorse a failed policy before agreeing to fix it is akin to firefighters demanding you endorse their failed plan of adding fuel to the fire before considering a water-based solution.” Another point of view is that what Greece cares about is the loan component of the program. It’s willing to take loans. It’s not willing to embrace an obviously failed “program” that thrust a large portion of the citizenry into dire poverty, unemployment and cold starvation. “It is akin to arguing with the firefighters over the brand of their hose while your house burns down.”

The single biggest argument against the eurogroup not coming to a compromise with Greece is the political blowback, especially for Chancellor Merkel. The German electorate trusted Merkel when she approved the first set of bailouts in 2010-2012. Those bailouts were for the benefit of German banks and investors, but never mind—she made a political decision to keep Greece in the eurozone, over the protests of some of her political opponents and a pretty big chunk of the electorate. This is leadership. This time, if no deal is reached and we get default, bank balance sheet woes, a Bundesbank bailout of German banks, etc., it will look like the original bailout was the wrong idea and she is an ineffective leader. Presumably Varoufakis appreciates Merkel’s political position. The German team may be dismissive and even insulting about the Greek game-theory aspect of these talks, but the fact remains that they contributed to a very bad bailout program that didn’t work, and their not wanting to admit it now is petulance, not good management. It’s not clear that Varoufakis needs Germany to admit it insisted on a bad program. That’s a good thing. If he and Djsselbloem can make a deal behind Germany’s back, all the better.

Truth be told, the FX market has a short attention span and is wearying of the Greek drama. On the whole, it expects a favorable outcome, favorable meaning no default and no Grexit. This doesn’t mean they are going to run out and buy euros. They still want to “buy on dips” and “sell on rallies,” but at some point, the range becomes unbearably narrow and we must get a breakout. See the triangle on the 4-hour chart. That’s when something decisive about Greece becomes a trigger. Until then, we will probably wobble among.

As for the ever-rising yield differential between the US and Germany—176 bp this morning—it doesn’t have the power it used to have in the early 1980’s, but it’s not chopped liver, either. At least one German analysis is calling for a substantial rally in German equities, since Germans are not into real estate speculation (unlike the rest of the world) and yields are so low. This seems logical but then so did the Neue Markt, which went down in flames.

Probably the bigger point about US yield is that the world doesn’t seem to need a safe haven these days. The dollar/yen is sending the same signal. We could get a continuing trend to higher yields at the longer end that more reasonably reflects relative growth and relative growth potential, European green shoots notwithstanding. It’s actually a Good Thing that inflation is not on anyone’s mind—either way. We have stopped hearing about the Fed’s balance sheet (which is entirely irrelevant for an institution that can print money).

We may get another euro rally-ette on a Greek deal or the seemingly perverse opposite—sell on the news. Longer-run, the euro “should” fall and not just against the dollar—sterling looks like it deserves its rally.