Greece is starting to become euro-negative

Outlook:

We have event risk arising from two corners this week, Greece and the Fed. Greece is starting to be euro-negative, but in fits and starts and not catastrophically, while the Fed is expected to give us very little this week, and perhaps nothing at all.

The theme so far is “this year but don’t freak out—hikes will be so gradual you will barely notice them.” We take “gradual” to mean “many months/meetings after the first one before we get the second one.” So far the market is not getting the “gradualism” message and remains focused on the timing of the First Hike, which is tiresome but in keeping with the fixed income gang mindset.

A problem could arise with today’s release of the May industrial production report, and the June Empire state manufacturing survey. Forecasters expect industrial output up 0.2%, with the manufacturing component up 0.3%. But the series has been choppy over the past year and a low or negative number would presumably scare the bond gang. Analysts emphasize that the Fed will probably repeat that the bad first quarter was a temporary aberration—but lousy industrial production numbers would make that an empty assessment. We worry that the Fed is in danger of becoming the BoJ, which hangs on to any tiny gain as “moderate” improvement, whatever the trend. There’s a lot of chatter about whether dissent means something different when it’s from a regional Fed president or a Board member, and the like. Some days the forecast dots are irrelevant and others say they mean more than the Statement. We say these niggles are only marginally interesting and not worth following.

Greece declares it still wants a deal but nobody knows what it is, even the Greeks. Simon Nixon in the WSJ has an opinion views masquerading as a news story but it’s very good however we label it. He points out that it’s possible the creditors don’t know what Tsipras wants because he doesn’t know himself. Syriza wants to get rid of the debt and carry on however it wants to. “Athens has convinced itself that all that stands between the grim present and a glorious economic renaissance is debt relief, thereby allowing it to regain access to financial markets to fund a Keynesian public-spending-led growth strategy.”

But debt relief without many conditions would turn the eurozone into a transfer union. It might not be a bad idea, but the eurozone “isn’t a transfer union and there is no political appetite in much of the currency bloc to turn it into one. Besides, even a transfer union needs rules and institutions to protect taxpayers from moral hazard. That, in turn, requires a much greater degree of political union and fiscal oversight, which is hard to reconcile with Syriza’s demands for maximum political sovereignty.” Nixon notes that big-mouth Varoufakis is silent on how a transfer union would work in Greece.

Besides, it’s not at all clear that debt relief is all Greece needs. Greece is unwilling to acknowledge the creditors’ judgment—“It was the vast expansion of this public sector that caused the crisis and it is the failure of successive governments to tackle the issue that has prolonged the drama. Although public-sector numbers have been slashed, very few jobs were lost via redundancies: Most were shed via generous early retirement programs that now weigh on the pension system and are crippling the public finances. Meanwhile, Syriza has vowed to protect existing public-sector jobs, salaries and working conditions.” Tsipras wants to transfer these costs to the rest of the eurozone. “But that isn’t the kind of currency union Greece joined. He must choose between keeping Greece in the eurozone and preserving public-sector privileges. He can’t do both.”

Let’s recall that a very long time ago (1998), Larry Summers wrote an article on why the EMU would fail in the end—it’s federalism without the transfer union aspect that makes it work in the US. In the US case, unemployment benefits, Social Security, Medicare and a whole lot of other federal transfers from the feds to the states keep the wheels moving. The federal government does not guarantee, even implicitly, any state debt, however, and that includes state public sector pensions, many of them union pensions. This is why various California towns and the entire state of Illinois are in or on the verge of bankruptcy. The Greek drama is thus a new textbook case for debate in what used to be called political economy.

And the final decision-maker may turn out to be Mr. Draghi, whatever he says about standing back and obeying the politicians. Draghi gives a quarterly update to the European parliament today, with a focus on how QE is going but he is certain to be taxed on Greece as well as bond market volatility. He may be even be criticized for saying market participants need to get used to volatility.

Some commentators note that the important thing is whether European banks take advantage of another round of Long-Term money on offer from the ECB on Thursday. It will be the 4th allocation, with €310 billion so far but banks perhaps having front-loaded and not having loan demand, after all. March saw demand at almost double the €40 billion forecast at €97.8 billion but this time the forecast is for demand as low as €75-80 billion. At a guess, folks will try to make bricks out of straw on this one. The important data is not how much the banks take from the ECB, but what they do with it—commercial and household lending.

Bottom line, the euro “should” fall on Greece but last week to Tuesday, according to the COT, traders reduced euro shorts. This is obvious on the chart, but why they did it is less obvious. It could be only position reduction or it could be true sentiment. This is a dogfight you don’t want to get into.

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