Euro, risk assets plunge again as repeat Greek elections loom and Spanish distress deepens
21/May/2012 • Currency Updates•
Fears of Lehman-like contagion gripped financial markets last week. The failure of Greek Parliament to produce a stable Government, as well as rumours of deposit flight from Spain’s troubled Bankia brought about a generalised flight to the safety of (select) Government bonds and the US dollar. Ominously, correlations rose across financial markets and asset classes. Now that the entire financial world is squarely focused on the outcome of the June 17th election in Greece, all risk assets are sold or bought as one. We point out that the European crisis is following rather closely the script we have described over the past few months. Consensus views and financial markets have converged very quickly towards our views,pricing in an increasing likelihood of a Greek EMU exit, a Spanish rescue, and a much lower Euro.
The Bank of England inflation report was quite dovish, and consistent with our out-of-consensus view that the purchase target is likely to be raised at one of the the next two meetings of the MPC. Growth expectations were revised lower. More importantly, although near-term inflation expectations were revised upwards, the medium-term forecast is now even lower, implying that the BoE considers the recent increase in inflation to be a temporary blip. The sharp drop in oil and energy prices over the past few weeks supports the BoE’s view, as does the increasing likelihood of financial contagion from the European disaster. We think the next 50 billion GBP increase in the purchase target will come either in June or in July, with a 50/50 split in the likelihood of each. For now, Sterling continues to behave as we predicted, acting as a low-beta version of the Euro: rising against the common currency, but dropping against the US dollar.
The dangers to the European Monetary Union that we have been pointing to since the beginning of the year have become the center of attention of financial markets. It has become increasingly clear that the only thing that can prevent a Greek exit from the Euro, a bailout of Spain and its banks, and potentially bank runs in the periphery is a dramatic about face in Frankfurt and Brussels, away from failed austerity policies and towards a proactive, fact-based and growth-centered policy. Outside of the dramatic Spanish and Greek headlines, economic data continues to point to a serious split between the fortunes of Germany and those of the rest of the Eurozone. A better-than-expected Eurozone GDP print of flat growth in Q1 was entirely due to German growth of 2.1% saar, while the rest of the area shrank by 0.7%. Unfortunately for financial markets, the critical Greek election is a full month away, so we expect to see a return to highly volatile FX markets where the Euro swings up and down according to the latest polls to be published, all within a clear downtrend in the EUR USD rate.
Our relatively sanguine view of US growth hinges on the fact that exports to the troubled Eurozone account for less than 2% of US GDP. This view received moderate support from last week’s data. Weekly jobless claims, the most important high frequency index in the US, have come back down, reversing the worrisome increase from the past few weeks. Retail sales were up slightly in nominal terms, but given the disinflationary environment, are still consistent with consumer spending growth near 3% in this quarter. Finally, the moderate rebound in the housing sector that we have been predicting appears to be taking place, and housing starts have rebounded more than 25% from their admittedly low bottoms of last fall. Overall, we maintain our view of growth in the 2 to 3% range in the US, and a very bullish view of the greenback, which is now benefiting both from US economic outperformance and from the dollar’s role as a safe haven.