Smart money building in expectations of default, bail-ins, and Grexit

Outlook:

The safe-haven dollar can only benefit from failures in important countries. Greece is important because it’s the first eurozone member to flirt with exiting the monetary union ex-periment and nobody knows how to think about it. Some say it’s okay and some say it’s a dis-aster of the highest order. As the ministers arrive at the Brussels meeting today, they are releasing some verbal bombshells. German FinMin Schaeuble said debt forgiveness is not allowed under the eurozone bailout rules, rejecting the IMF report in its entirety. Dijsselbloem said he hasn’t yet seen the Greek pro-posal. “It's up to the Greek government to show how it can agree with its creditors.” It’s clear the euro-zone officials are viewing Greece as a failed state that has a tough row to hoe to demonstrate it qualifies to remain a member.

China is important because it’s the world’s second largest economy and the leading creditor of the world’s first largest economy. Chinese market participants and the Chinese government are not ready for prime time, as MSCI detected when it declined to add China to one of its indices. The response to the drop in the equity markets, including intervention but also the shocking ability of companies to suspend trading in their own shares, is ample demonstration that China may fully understand free markets but does not accept them, or at least accepts the upside but not the downside.

“Capitalism with a Chinese face” is malarkey. In a true capitalist economy, the government doesn’t wor-ry about social unrest or getting thrown out of office because of a stock market event, or at least not much. In the US in the 1930’s, the unrest consisted chiefly of investigating and prosecuting miscreants who abused privilege (Whitney fraud, Peccora hearings). We have to assume that China is taking strong policy initiatives to tame the bursting bubble because it fears a political backlash. Ah, so when will we get free markets in interest rates and the currency? As we have been asserting for years, talk of the yuan supplanting the dollar as the top reserve currency is poppycock for a very long time to come. The Chi-nese propensity to meddle in markets is fatal to that development, no matter how big the Chinese econo-my.

This is not say China is a failed state like Greece. It is to say that demand for the yuan and Chinese as-sets is deep in the soup.

You might not know it from relatively stable markets, including the FX market, that we are actual-ly in a state of Shock. And the smart money is building in expectations of default, bail-ins, and Grexit. Instead of a state of limbo (Grimbo), we are likely to get a series of additional Shocks. A Shock can be something already in the mix for some time that still has the power to surprise when it materializ-es for real. In this instance, expectations were upended fairly fast. For months the consensus was that the eurozone creditors would blink, at least a little, and make concessions to allow a deal with Greece. Then most people thought the referendum would be a “yes” vote on the grounds of all those polls showing the Greek public wants to stay in the eurozone.

Now the press reports the eurozone officials are royally ticked off and unlikely to make any deal differ-ent from the one they already offered. This means they refuse to acknowledge the IMF report last week saying Greece needs debt forgiveness and an additional €50 billion. Schaeuble dismissed it this morning in its entirety. Worse, Reuters reports that the Sueddeutsche Zeitung says the new Greek proposal to be presented today is barely different from the creditors proposal that was rejected in the referendum. It fiddles with the VAT and cuts defense spending a little. The implication is that the eurozone creditors have withdrawn their proposal, reject all the IMF’s ideas, and want Greece to offer up more concessions.

And to be fair, the creditors are not under any obligation to heed a referendum, and in any case, the Greek government and the Greek public want something they cannot have—free money without the re-forms that would make repayment likely. The core problem, not to beat a dead horse, is that for decades if not millennia, Greeks have refused to pay taxes. This shows a fundamental lack of respect for law. Creditors do not have to lend to people who have proven themselves to be deadbeats and who persist in the behaviors that keeps them unable to repay debt.

We learned in the Latin American credit crisis that started with Mexico in the 1980’s that once default got rolling, all kinds of borrowers jumped on the default bandwagon, including those who literally had the ability to pay. We knew, because we had their financial statements. For years afterwards those bor-rowers would try to come back for credit and be turned away for bad “character.” We probably need to assume that today’s eurozone creditors have properly trained commercial bankers advising them that you just don’t lend to deadbeats. It’s throwing good money after bad. Therefore, Greece may have to give up more this time around than last time in order to get any deal at all.

If credit is not to be made available, that leaves charity. The mind boggles.

Eurozone officials are reported to be burning midnight oil figuring out how, exactly, to expel Greece. Numerous strategists now consider Grexit as “high probability” (Barclays) and “more likely than not” (JP Morgan). Commerzbank says it would take a miracle to avoid Grexit. While it’s true that any country can use another country’s currency as its own and thus Greece doesn’t have to give up the euro, it has to get its hands on enough to run the country. This is awfully hard to do when everybody and his brother is hoarding euros under the mattress or sending them abroad. It is literally a question of getting the money to have a money supply.

Because it’s unlikely Greece will have enough euros, it will have to create a new currency. It may not be named the drachma but whatever it is, it will cause terrible, awful disruptions. Every shop’s cash register will have to be re-calibrated, not to mention the accounting and computer systems of every bank and business. The international system has a supremely efficient clearing methodology so the new currency could be used internationally in no time—but will anyone want it? Devaluations, heavy and recurring, are only to be expected.

There is no other way to describe Greece as anything other than a failed state. We saw in a blog that Kathimerini claims that 16 of 18 eurozone members favor Grexit. Last evening the FT had a headline saying “Eurozone gives Athens last chance” with a refreshed proposal Tuesday night. But the Greeks don’t get it. Tsipras thinks he won something with the referendum. He didn’t. His hand is actually weaker. Therefore the probability that the newest Greek proposal will be accepted is almost ze-ro.

While the FX market may be fully expecting Grexit and all that entails, including the final word to Draghi to pull the plug, the flood of euro sales should far outweigh whatever euro-buying gets triggered as hedgers and carry-traders cover. Grexit is a big deal. The euro “should” fall. At this point, the only thing that saves the euro and makes a rising euro a real possibility is capitulation by the creditors, which itself implies a prior capitulation by Greece. And what’s the probability of that, today? Later, maybe, but not today. The creditors are really, really angry, with justification, and today is not the day. This week is not the week, either.

But meanwhile, off in the corner, there is a growing perception that Grexit and the Chinese stock market crash must stay the hand of the Fed. The FT writes that “Investors believe the Fed will remain in ‘wait and see’ mode” come September, and the Market News fixed income analyst verifies that this is the growing sentiment. Is it true? Well, maybe. We’d like to think the Fed gives little weight to external af-fairs as not in its wheelhouse, but Stanley Fischer, the global stability guy, might not agree. Here’s the rub—if the Fed delays because of Greece, it is contributing to a Lehman moment, isn’t it?

We hardly ever say it, but we see the rising dollar trend as gathering momentum and real support.