FINANCIAL REVIEW

Greek Drama

Sinclair Noe — January 6, 2015

Podcast: Play in new window | Download (Duration: 13:16 — 6.1MB)

DOW – 130 = 17,371
SPX – 17 = 2002
NAS – 59 = 4592
10 YR YLD – .08 = 1.96%
OIL – 2.23 = 47.81
GOLD + 14.20 = 1220.30
SILV + .36 = 16.65

The 114th Congress convened today for the first time. Mitch McConnell was selected as Senate Majority Leader. John Boehner was elected to a third term as Speaker of the House. The good news is that it won’t take much effort to outperform the 113th Congress; that bar was set pretty low.

Let’s quickly cover the economic data. Commerce Department report factory orders dropped 0.7% in November. Orders for durable goods fell 0.9%, while orders for non-durable goods fell 0.5%. The setback was paced by declining demand for business equipment such as electronics and industrial machinery.

The Institute for Supply Management said its nonmanufacturing index fell to 56.2% from 59.3% in November. Yet readings over 50% signal that more businesses are expanding instead of contracting and the index is coming off a nine-year high, so some cool down might be inevitable. Retailers, hotels and restaurants topped the list of the 12 non-manufacturing industries that reported growth in December, another sign that gains in employment and cheaper gasoline are giving American households a boost. Cheaper fuel helped drive down the index of prices paid at service providers to 49.5, the first time since September 2009 that more companies reported costs were falling than rising.

Cheaper fuel doesn’t really describe what is happening with oil prices; it’s more like a collapse, or a meltdown, at least for the past few days. Yesterday WTI crude dropped about 5%, and today almost 5%.

Today, Saudi King Abdullah said his country would deal with lower prices with a “firm will”, meaning they have no plans to cut production to prop up prices. Other oil producing countries such as Russia, Venezuela, and Libya can’t afford to unilaterally cut production; same deal for frackers and oil shale players in the US.

Lower fuel prices are deflationary, as confirmed today by the prices paid index, and that was reflected in the bond market, as the 10-year treasury yield dropped below 2% for the first time since May of 2013. Lower bond yields translate into higher bond prices and carry some benefits for the economy. Lower bond yields mean lower mortgage rates, a boon for homeowners looking to refinance their home loans at lower rates, and lower rates on other loans to consumers and businesses. Lower yields are not so great for banks, which face a tighter margin on their loans, and today the shares of major bank stocks moved lower. Also, lower rates are a challenge for savers and people on fixed incomes.

And don’t forget, the lower yields are set against a backdrop of the Federal Reserve’s continued warnings that they plan to start tightening monetary policy to force rates higher. Maybe the Fed will move forward with tightening because lower oil prices are acting as a $1.6 trillion quantitative easing program for the world economy. But the bond market is also telling us the global economy is weak.

And it’s not just the US; the yield on the German 10-year government bonds fell to a record low of 0.44% while Japan hit a new nadir of 0.28% and the UK reached 1.58%. Now, you might be wondering why Germany pays about 150 basis points less on their 10-year bonds than US 10-year bonds. Are US treasuries riskier than German bunds? No. US Treasury bonds are about as safe as you can get. The United States is not at risk of default, and in the doom and gloom scenario where the US might default on its debt you wouldn’t find German or Japanese or French debt to be a safe harbor. German bonds are denominated in euros, while US bonds are denominated in dollars. So, higher US rates don’t reflect fear of default; they reflect the expectation that the dollar will fall against the euro over the decade ahead. And the reasoning behind that is because right now the Eurozone is dealing with very low inflation, right on the edge of deflation; while the US is dealing with inflation at almost 2%. If you look at the expected inflation implied by yields on inflation-protected bonds relative to ordinary bonds, they seem to imply roughly 1.8% inflation in the US over the next decade versus half that in the euro area, which means that the inflation differential explains about 60% of the interest rate differential.

Also, right now the US economy is strong; certainly stronger than the Eurozone, but the bond market is forward looking, and the expectation is that over the long term, say 10 years, the 2 major economies will revert to a more normal, more level playing field, which means the dollar would fall and the euro would rise relative to each other. Or another way of looking at it; the US economy is sprinting and will eventually need to pause and catch its breath, while the Eurozone will eventually manage to dig itself out of the hole it is in.

Of course that notion is based on the idea that the Eurozone will not splinter on the periphery and that they will actually stop digging a deeper hole. This has been the topic of heated debate ahead of the January 25 elections in Greece. Euro Union officials have been meeting in Brussels and they say Greece will stay in the Union; the matter is settled. Still, the democratic process in Greece is a threat for Germany and its allies. We’ve seen this before. In 2011, Greece announced a referendum to determine if the Greek people wished to adopt the Euro Union imposed austerity program. The Greek Prime Minister Papandreou was forced from office and replaced by a Euro Union selected bureaucrat, a former vice president of the European Central Bank. Democracy failed and the Euro bankers and German austerity prevailed.

How did that work out? Well, 3 years later more than one million Greeks have lost their jobs; unemployment is at 25%; youth unemployment is over 50%; one-third of businesses have failed; the economy has contracted by about 25%; pensions have been cut in half; the health care system has collapsed and infant mortality has shot up by more than 40%; the Greek economy is caught in deflation; and austerity has managed to increase public debt from 130% of GDP to 175% of GDP. The election later this month is not so much about the Greeks wanting to leave the Euro Union, as it is about the Greeks wanting to put an end to austerity programs that have not worked.

Austerity has been tried elsewhere. Two years ago France was labeled the problem child of the Eurozone. The Austrians were certain that France would explode in hyperinflation unless they were forced to tighten their belts and cut their debt. Some pundits called France worse than Greece. The big difference is that France was much bigger than Greece and they refused to take their marching orders from the Troika or the Germans; and the result is that today the French economy has better economic growth than Britain since 2007, and the French government can borrow with an interest rate of 0.8%, just a smidge more than Germany, and less than the US. France still has economic weakness, but it did not implode and the Eurozone did not disintegrate.

Der Spiegel reports that Angela Merkel thinks Greece can be ejected safely from the euro, if the anti-austerity Syriza party wins the elections on January 25 and carries out its pledge to tear up Greece’s hated “memorandum” with the EU-IMF “Troika”. It was revealed last week that Germany offered Greece a “friendly” return to the drachma in 2011. The leaked minutes of an IMF board meeting in May 2010 admitted that what took place was not a “rescue”: Greece should have been given debt relief, but was instead sacrificed to save the euro – and the banks. It is the failure of Brussels and Berlin to acknowledge this that makes Greeks so bitter, and this crisis so politically explosive. This time, Berlin seems almost eager to finish the job and push Greece out of the Union. Syriza says it doesn’t want to exit the EU, but it will exit the bailout and demand a 50% cut in outstanding debt.

Meanwhile, European Central Bank President Mario Draghi has been saying that he wants to stimulate the Eurozone with a trillion-euro of quantitative easing to head off deflationary forces that threaten to bog down the Eurozone. And if Draghi’s stimulus plan is big enough to make any difference it would involve the purchase of sovereign debt. The next ECB meeting is scheduled for January 22. The Greek snap election is scheduled for January 25. The question is whether Draghi will agree to buy Greek bonds 3 days before the possible election of an anti-austerity, anti-bailout party that has vowed to not pay that same debt. Any bond buying announcement could be seen as interfering in the election. And Draghi can’t just announce a huge bond buying program that excludes Greece’s bonds from the purchases; not unless he wants to throw the democratic process under the bus; and it would likely lead to the very Greek bond sell-off that the ECB wishes to avoid.

And the battle is not just Greece versus Germany. Italy’s debt ratio has spiked from 116 per cent of GDP to 133 per cent, despite austerity and meeting EU deficit rules. The Bank of Italy warns that any further drift towards deflation could have “extremely grave consequences”. Italy, Spain, Portugal, and even France could side with the Greeks. The southern European nations have gone through crisis only to see their debt burden increase while GDP has been flat or even contracting; the more they cut spending to balance the books, the more the economy contracts.

Draghi might just delay any decision, but meanwhile the Eurozone is tipping into outright deflation, and delays would be seen as a sign of weakness, and exacerbating that problem you have low energy prices, which have a deflationary impact. In the past few weeks, the ECB has been trying to downplay the deflation problem.

So, even if Greece votes against austerity, there is hope that cooler heads will prevail and the Union will remain intact, and over time the Eurozone will dig out of its current hole. That is the likely plot, but there will be a big Greek drama played out over the next 3 weeks and nobody is quite certain how the story ends.