by Don Alexander, MBA
Associate, RSD Solutions Inc.
Financial markets loved the rescue package as equity markets rallied and the euro surged. However, this short-term good news for markets did not last as Greek politicians feuded among themselves and Eurozone officials. As Eurozone policymakers threaten to with hold Greek aid, it raises the question of whether Greece may exit the euro. The fallout for financial markets could be costly.
Near-term, the package avoided sovereign default and a banking crisis. .The rescue package accomplished three objectives: it provided a temporary fix for Greece, backstopped banks writing down Greek sovereign debt and provided a temporary backstop for sovereign debt.
Long-term, the rescue package is bad news for banks, financial markets and the euro. Banks will experience a credit crunch as they struggle to meet capital adequacy ratios, the resulting austerity could create a fiscal contraction and provide a negative feedback loop for banks and sovereigns. It failed to address three specific long-term issues: the package is too small to cover fallout from Italy or Spain, the lack of ECB involvement is a mistake and failed to address treaty reform and long-term monitoring of budget deficits by Eurozone authorities. Eurozone policymakers may need to consider another rescue package by next summer.
The Euro rallied, after the package was announced, from the positive sentiment. However, this rally does not appear related to yield differentials. Current Euro-US short-dated bond rate differentials would suggest a weaker euro against the dollar. Economic fundamentals and market sentiment are clearly out of line and pose potential downside currency risks once the market digests long-term implications of the package.
Bond investments tend to be one of the largest cross border flows. Any divergence between currency values and rate differentials suggests that decision to buy and sell currencies may be related to other factors. It is possible that as European banks may be repatriating funds in anticipation of reducing their balance sheets. The rising losses on Greek sovereign debt and bank shares trading below book value limit flexibility in raising funds from private investors. This suggests that shrinking the balance as one method to meet capital requirements.
When banks start a deleveraging process, the first adjustment is made to overseas business that is considered non-essential. A second adjustment may occur when banks attempt to reduce their short-term funding requirements, especially in non-core currency markets away from the euro. In particular, this could impact trade finance and commodity finance where European banks are major players.
The fact that the euro/dollar is not trading in line with rate differentials suggest other factors may be supporting the euro. This has allowed the euro to withstand selling pressure against the dollar. This may allow the euro to be well supported against the dollar as long as repatriation flows continue. As banks reduce their balance sheets, the impact is deflationary for markets and negative for asset prices. These policies will serve to weaken the fiscal positions of Eurozone governments, add additional pressure to bank balance sheet and increase the potential default pressure on Greece. The only long-term answer is ECB involvement and implementation of euro-wide reforms in Brussels. Otherwise, there is growing sentiment that Greece may exit the euro
Therefore, the prospect of weaker growth prospects and the gradual ending of financial institutions repatriation are negative for financial markets and could spell euro weakness as economic fundamentals reassert themselves or Greece decides to exit the euro. What is your hedging strategy?
