Why has the Euro been so resilient in the face of the growing Greek crisis? Where from here?

News about the Greek negotiations has steadily deteriorated, culminating in Monday’s emergency summit (although the agony could conceivably be extended until 25-26 June Heads of States of the Union meeting). Yet at the same time the euro has been flat to rising: EURUSD is up nearly 3% on the month and 0.6% last week despite the small setback on Friday (the EUR TWI stats are similar). So why has bad Greek news been good for the Euro? Does that surprising outturn hold when we dig deeper? And what does it tell us about what factors will affect the Euro in the near term and further out? In addressing these questions I draw on the specifics to the Greek situation, the broader asset price picture and the global macro/policy backdrop.

Bottom lines: the growing difficulty of keeping euros in Greece means that we have probably gone past a tipping point whereby, unlike in recent weeks, bad news emerging from the Greek negotiations will be also be bad news for the euro. Indeed, a successful outcome to the negotiations (still the most likely case despite the probabilities shifting adversely in recent days) may also see EUR fall – as the funding currency nature of the single currency persists in the risk on environment that is likely to follow a deal being sealed. Given the considerable uncertainties at play, with many moving parts, the risk-reward is anything but great. But understanding the mechanics underpinning recent developments will nevertheless be useful going forward. In particular, the recent importance of risk aversion in supporting EUR implies that the next leg lower in EURUSD will be more likely if improving US data can be accompanied by buoyant market risk appetite. That extra requirement (upside US data surprises may not suffice) places extra onus on the Fed managing market conditions. And an extra layer of complication is that the Fed remains wary of too sharp USD rises (alongside moribund inflation and inflation breakevens). The end result may well be a slow and steady grind lower in EURUSD rather than the fireworks from mid-2014 to earlier this year. And short EURGBP positions may offer useful diversification benefits.

The facts


So how can we rationalise that constellation of developments? They seem to reflect a combination of developments – encompassing factors specific to the Greek situation, market dynamics in the post ECB QE world and relative economic prospects. In particular:

(1) Markets’ base case is that last-minute deal will be done, potentially kicking the can down the road again
• EA has a long history of last minute deals (which kick the can down the road)
• Merkel, probably the most important player, has sounded more positive (if firm) last week
• The Greek government are presumed to be rational and to eventually compromise, given the severe pressure on Greek banks and hence prospective economic implosion without a deal
• A deal along the lines of Blanchard’s blog from last week could be a runner
But “no deal” probabilities have risen, with internal Syriza politics representing hard-to-quantify wildcards.

(2) Spillovers to other peripherals are viewed to be contained should no agreement be reached
• Greece only 1½% of Eurozone GDP
• Various ECB backstops in place (OMT, TLTRO, QE) are deemed credible in forestalling tensions
• Any Greek debt default will be to the public sector rather than private sector (banking sector not under threat, except in Greece)
• Rest of “periphery” in better shape as EA recovery has spread & the banking sector healthier after AQR
o So market consensus seems to be is that systemic pressures from “integrity of EMU” having being violated are unlikely to show up near term
Key issue is whether this covers the full range of spillover channels: could the prospect of bank holidays and capital controls turn ripples on the placid lake into waves?


(3) EUR supported by rise in uncertainty, given that EUR has become a funding currency
• Combination of QE and negative deposit rate has turned EUR into a funding currency (paid to short EUR)
o Evidenced by negative beta on equities (even more so that JPY)
• EA large current account surplus may have contributed (element of “safe haven”, although does not have the substantial international asset position of Japan)
• Rising risk aversion has led to unwind of EUR shorts (CFTC positions) even if that risk aversion is generated by Greek developments
• Rise in EA long rates & long rate uncertainty may be amplifying the effect:
o Reduced EUR funding by non-EA residents (smaller risk-adjusted rate differential)
o Higher discount rate undermines EA equities (relative EA underperformance), leading to unwind of redundant FX hedges (foreign inflows into EA equities were largely FX hedged, and so did not support EUR around QE, but equity price falls means that foreign investors are now over-hedged)
o Interacts with technical resistance levels being breached: further near-term EUR strength
• Key issue is whether recent FX-equity correlations will persist over the next few days or will be swamped by the outcome of the negotiations


(4) Limited trading, given uncertainty about EUR reaction in the different scenarios
• Markets unsure how to react in the different “deal no deal” scenarios, on top of the difficulty of assigning probabilities to the different scenarios
• Hard to trade based upon correlations persisting around a potentially unprecedented event

(5) The economic/rates divergence story has gone into reverse
• Apparent turnaround in EA economic situation & higher yields more important than Greek concerns
o Threat of EA deflation disappeared
o EA PMIs and GDP have improved, signs of healthy domestic demand (although off boil in latest)
o Oil price fall more beneficial to EA than US as doesn’t have oil production sector to offset the consumption boost from lower inflation
• US data/FOMC uncertainties: market skeptical about the bounceback from Q1 weakness or early Fed liftoff
o Need sequence of upside data surprises, broader than labour market (inflation!)
o Lower FOMC dots (was Yellen one of the 7 members expecting less than two 2015 rate hikes?) mean a coin toss between September & December liftoff (despite acknowledging better data)
o FOMC likely to remain cautious about impact of rise in USD and won’t want to add to it
o Risk-management rationale for delayed liftoff given lack of pickup in inflation or breakevens
o Perception that recent oil price upside less impact on Fed policy than ECB (Fed focuses on core PCE deflator versus headline CPI for ECB)
EUR bounceback coincides with 10y yield differentials narrowing
A key issue is whether markets’ switcharound in views has gone too far


(6) The flow-based drag on EUR has waned
• Sharp net portfolio outflows from EA in H2 2014 have not continued into 2015


Near-term prospects (next week to a month)
• Difficult to trade EUR near-term: low risk-reward given the complicated dynamics and considerable at play
• But bias to EUR weakening in either scenario, volatility likely to pick up substantially if a deal is not obtained on Monday (less so if signal that deal in prospect 25-26 June)
• “Deal” scenario (70% probability?) most likely to be associated with EUR continuing to behave as a funding currency (risk of ECB policy extension rather than early tapering)
o Deal positive for “risky” EA asset prices and reduce volatility, raising attraction of EUR shorts
o Deal wouldn’t have any substantive impact on EA growth/inflation prospects or ECB policy, so in effect re-setting clock to before Greek worries surfaced and risk aversion undermined EUR shorts
o But need to be aware of breaching upside resistance levels
“No deal”: likely a spike in risk aversion and lower risky asset prices but the recent EUR-equity correlations are less likely to persist (although would not completely rule them this out)
o Aggressive ECB action, probably expanding QE, counteracts nascent EUR appreciation pressures (despite Draghi telling markets to “get used to volatility”)
o And in any case those nascent pressures could be smaller given that a “final no deal” would be a very kettle of fish to previous ones (regime change, tipping point)
o Transmission channels that haven’t had sufficient imagination to think of will probably emerge (known unknowns) causing knee-jerk EUR-negative reactions
o E.g. banking sector contagion may to be harder to contain than sovereign contagion, with negative effects on equity prices and risk appetite
o So EUR “irreversibility” fault-lines caused by Greek no-deal could be exposed earlier than during the next downturn (risk does not seem to be being significantly priced)
• But impact of no-deal scenario would also depend on how it were to be presented (confidence is key):
o Degrees of GREXIT, door could well be left open to subsequent deal rather than instantly slammed shut (when Greeks realises how bad things could get,
o Internal Syriza politics represent a wild-card

Longer-term prospects (2months – 12 months)
• Slow EUR grind down, but requirements broadening
• Market has taken a glass half full view of recent EA data, but probably too early to rule out structural growth headwinds and risks skewed to expanded ECB QE action rather than early taper
o EA data surprises have come off the boil, lending flows need to pick up to give the recovery legs, EUR depreciation has yet to translate into a meaningful pick up in net trade
o Many of the asset price rises associated with QE have partially retraced
o Can question usual interpretation of higher real interest rates and steeper yield curve as signalling stronger growth momentum: unhelpful policy tightening instead?
o Room for net EUR outflows to resume once market conditions settle – recent short position squeeze makes trade more attractive but
o EUR may mirror temporary JPY pause after initial BoJ QQE driven fall
• Challenge for EURUSD downside is to tread path of upside US data surprises and Fed tightening perceptions while not undermining risk appetite: EUR funding currency status requires risk-adjusted return differentials to not be undermined by higher volatility.
o Fed remains wary of further/rapid USD rises, wider labour market slack measures , low inflation and inflation breakevens
• Next leg down in EUR likely to be slower and smaller than the mid-2014-early 2015 fall
• Given US data/FOMC uncertainties short EURGBP offers useful diversification for short EURUSD positions
o UK wages are showing greater signs of life, inflation breakevens look better anchored,
o Housing market, consumption and PMIs seem solid
o UK current account deficit and BREXIT are distant risks that seem unlikely to be priced near term
o MPC will likely be pragmatic about sterling strength if it reflects fundamental economic divergences




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