Jun 29/15 – Don’t short into Sunday’s open

2015-06-29 9am EDT  |  #China #El-Erian #Europe #Greece

Friday night’s surprise from Greek Prime Minister’s Tsipras certainly threw the markets for a loop. After what seemed like an endless series of deadline extensions, the Europeans finally told the Greeks to shit or get off the pot. In what had surely been the plan all along, the Greek government quickly called a referendum to let the Greek people decide if they should accept the proposed deal. This was a brilliant strategic move by the Greek government. There was little chance the Europeans would acquiesce to all the Greek’s demands, so at a certain point, an imperfect deal would have to either be accepted or declined. Either way, the Greek government would be blamed. It was a no-win situation for them. So instead of displeasing everyone, they threw the decision back to the Greek people. They in essence said “we have negotiated the best deal we can for you, now you decide if you want it or not.” Shrewd.

The Europeans were once again caught completely flat footed. And here in lies the problem with this whole decision. The Europeans wanted the Greek government to shove the program down their people’s throats. When that didn’t happen, the Europeans immediately came up with excuses. Technically the Europeans’ deal offer expires Tuesday night and the referendum needs a week to be set up, so there is formally no deal to either accept or deny. Really? Come on Europe… You have extended these negotiations more often than Lindsay Lohan has put off step nine of her AA program. Getting hung up on another few days just makes them look like spoiled sports.

With all this uncertainty, the Greeks were forced to announce their banks would not be opening Monday morning. The markets did not take this well.

Sunday night’s open was 40 handles lower on the S&P 500.

And a flight to quality gapped the US Treasury market higher.

Although stocks are still lower and bonds higher from Friday’s close, the worse levels were seen right near the open on Sunday night.

As the market has realized the end is not coming crashing in, the markets have stabilized and are trying to recoup their moves.

It will be interesting to see if this trend will continue into the US session, and whether by lunch time the whole Greek situation will once again be regulated to the back burner.

Just a couple of points about Greece

There is so much being written about the Greek situation I feel there is little I can add. But I would like to highlight two important thoughts.

For the short term, the only thing that will matter is whether the ECB will continue funding the Greek financial system. Draghi has mouthed some sympathetic words about respecting the will of the people to decide to their own fate, but if he doesn’t find a way to advance more money through this Greek bank run, the European financial system will grind to a halt. He needs to keep all the gears lubricated until the deal is either rejected or accepted. My suspicion is the ECB has a plan, and that there is no way they will pull out now at the last minute. If anything I expect them to do too much, but you never know. For this week’s trading, the actions of the ECB will mean everything.

When it comes to the longer term, although it feels like the Greeks all want to reject the deal, the first polls are reporting the majority of Greeks will vote in favour of accepting the Europeans’ offer.

Although Prime Minister Alexis Tsipras urged Greeks to not approve the creditor's bailout agreement terms, the first polls in Greece find that most Greeks favor the deal even if it includes a new memorandum.

In a poll conducted by Alco for the Greek newspaper Proto Thema', 57% of the participants said they would vote yes in the upcoming referendum, favoring a deal.

Another poll conducted by Kapa Research for To Vima' found that 47% of the population will vote yes approving the agreement, while 33% will vote NO.'

Obviously it is still early, but it is interesting. It is not what I would have expected.

Former PIMCO CEO does not think this matters. He is downright gloomy about Greece’s prospects:

“There’s an 85 percent probability that Greece will be forced to leave the euro zone” in the next few weeks, El-Erian said in an interview from New York. “What we are seeing here is what economists call the sudden stop, when the payment system stops. The logic of a sudden stop is a massive economic contraction, social unrest and it’s going to make continued membership of the euro zone very difficult for Greece.”

Although the risks of the Greek situation devolving are quite high, I think El-Erian is overestimating them. He sees only a 15% chance of Greece staying in the Euro Zone. I guess that’s what makes a market, but I am much more in the 5050 camp. It will be close, and it could topple either way, but a Grexit is not quite such a sure thing. If El-Erian represents consensus, then the surprise might be on the green side and not the red.

Panic in China?

Everyone is focused on the Greek news, but over the week-end there was also some big news out of China. From the FT:

China's central bank has cut benchmark interest rates to a record low and lowered the amount of reserves certain banks are required to hold, in apparent response to Friday's Chinese stock market slump and continuing economic weakness.

It was the fourth time the People's Bank of China had cut interest rates since November. The PBOC said on its website on Saturday that the one-year lending rate will be reduced by 25 basis points to 4.85 per cent effective June 28 and the one-year deposit rate will fall by 25 basis points to 2 per cent. Reserve ratios for some lenders will be cut by 50 basis points.

Many financial pundits are claiming the cut was in response to the recent drubbing in the Chinese stock market.

Over the past two weeks Chinese stocks are down 25%! That is ugly. No couching that in a positive light.

"This is the best time for them to cut interest rates and the reserve requirement ratios," said Shen Jianguang, chief Asia economist at Mizuho Securities. "If they had not acted, on Monday there would have been real panic in the stock market.

"It's a signal that the government does not want to see a collapse in the stock market", he said, adding that real interest rates in China remained very high and investment continued to decline but the PBOC could not move before this because of the stock market bubble.

"The rate cut is a necessary step in the right direction," said Wang Tao, China chief economist at UBS. "Real lending rates are still significantly higher than a year ago. High real rates [coupled with] a weak economy with deflationary pressures means a heavy debt service burden on the real economy, both the corporate sector and local governments."

I don’t know if a collapsing stock market was the reason for the cut, or whether it was a symptom of the struggling economy. But I would be hard pressed to believe the Chinese authorities are tuning their monetary policy for every squiggle in their volatile equity market. Stock prices are most likely reflecting the monetary conditions as opposed to dictating them.

There had been some hope that China was about to experience an economic uptick. Remember the Druckenmiller argument the stock market rise signalled a coming economic boom? (April 2715 – Druckenmiller says “Don’t Fade the Banana Stand Guy”) There were definitely some hopeful signs. Industrial metals, which had been going down for years (and in the past have mirrored Chinese growth), appeared to bottom.

We had a month of a solid rise, but over the past few weeks, it has slumped back to the lows. I know the Chinese economy is in the process of transforming from an export and infrastructure based economy, and this transformation will make their growth less correlated to industrial metals, but I don’t think the Chinese economy will bottom with this indicator hitting new lows.

So what is going on? Why can’t China get off the mat? I think the answer is easy. In this day and age of limited economic growth, a country’s relative exchange rate movement is the most determining factor in marginal economic change. There is precious little growth to go around, and the countries that are most aggressive with stealth competitive devaluations benefit the most.

China has a soft peg to the US dollar. As the US dollar has rallied over the past year, the Chinese Yuan has come along for the ride. Have a look at this trade weighted index of the Yuan:

The Chinese currency is relentlessly being driven higher. This is weighing heavily on their economy. We have now hit a point where the Yuan is so expensive that instead of China accumulating foreign exchange reserves, they are flowing out.

Why is China allowing this to happen? The Chinese government is attempting to rebalance their economy. They want to become less dependant on exports. A stronger Yuan is one way to achieve this.

But I think the real driving factor behind China’s willingness to allow their currency to appreciate so strongly is their desire to be part of the IMF’s reserve currency basket. The Chinese are keenly interested in achieving reserve currency status. They are willing to take the short term pain of a strong currency in exchange for the coveted status.

It is painful, but I don’t think the Chinese alter their policy until a decision is made. Meanwhile, their economy teeters on the edge of monetary conditions that are too tight. Since they will not touch the peg, expect them to continue gradually walking down interest rates. This will all be window dressing, the next big decision is what happens when they are either accepted or denied entry in the IMF reserve basket. That will be the trigger Everything until then is fine tuning around the edges…

Thanks for reading,

Kevin Muir

the MacroTourist