1-7 January: Oil & Euro Lowest Since Lehman As Grexit Fears Loom, EU In Deflation

What a way to start 2015. The first deflation in the EU since 2009, record low yields on German sovereign debt, global energy prices keep tanking, US equities down for 5 consecutive days, and the news (or not) keeps flowing. For the record, major equity indices have started 2015 with the worst performance since the financial crisis of 2008. Whatever remnant of the 2014 "Santa Rally" turned out to be a ghost in a shell, and has now spooked global market participants.

2 major global macro risks lay as major speed bumps going forward. They need no further introduction. The continuing collapse in global energy prices (and all negative contagion effects), and heightened fears that Greece will leave the EU. We have had a lot more coming from restless news wires in the 7 days that have elapsed New Year's Day but a lot of those were noise.

Other noteworthy developments orbit the tragedy of AirAsia's Flight QZ8501 in which the latest reports of visual contacts with the crashed aircraft's tail section. The entire European Union has today slipped into deflation after official figures printed -0.2% over December 2013; prices have never slipped into negative territory since 2009. As we go to print, 12 people were killed in what seems to have been another terrorist attack by gunmen in the city of Paris, the worst Paris has seen in 20 years.

Update: One gunman has turned himself in, while the other 2 remains on the loose; both are radical Jihads from reports

Below, we succinctly highlight the key drivers if volatility in the past 7 days. While we do not plan to go into depth on the topics covered, readers can look forward to a more comprehensive analysis of Europe's messy morass in the weeks to come.


Greece Holds Europe Hostage As Voters Prepare To Elect Euro-skeptic Party

The past week has been all about ratcheting up the "Grexit" rhetoric across the markets. Readers should be no stranger to the situation in Greece and the entire periphery of the Euro Union, which we touched upon in our last update preceding the New Year. The risk has indeed never been greater as it seems Germany has openly voiced that it won't be blackmailed by a Greek plunger. Remember, Greece is bounded by €240bn to the Troika under the various bailout packages extended to her.

 Credit default swap (CDS) markets in Greek debt have been pricing in ever high default probabilities on GGBs as spreads have soared since September 2014 to heights not seen since June 2014

Credit default swap (CDS) markets in Greek debt have been pricing in ever high default probabilities on GGBs as spreads have soared since September 2014 to heights not seen since June 2014

Although the plunge in the value of the Euro currency against major FX was in part due to more bluster from ECB when Mario Draghi was cornered into hinting of sovereign QE in the not so distant future, Euro weakness was mostly fueled by fire in the Greek Parliament and politicians in limbo. 10 year GGBs (Greek Government Bonds) are now yielding well north of 10%, the highest in 15 months. There are a myriad of dynamics at play in the Greek Theater but the chimera behind the red curtains still remain a "Greek Exit" from the currency bloc; this is commonly known amongst market participants and commentators as "Grexit". Readers should acquaint themselves with this, because we believe there will be much more volatility from this trench.

German magazine Der Spiegel notes that if Syriza does win parliamentary elections with a majority, German officials believe that a Greek exit would be almost unavoidable and have therefore openly expressed over the weekend that it believed the Eurozone would be able to sustain such a shock. We believe the Greek weight in the balance is on a triply scale and it won't be easy to condense all opinions and projections until exit poll results are released on the 25th of January.

Over the next couple of days, the mouth pieces of the Bundestag would eventually come out to downplay the risk of a Grexit and affirm solidarity in Greece's promise to stick to current fiscal reform and austerity pathways.

To wit, Angela Merkel had this to say about Greece just days after her party pulled a stint of reverse-psychology: "I as German chancellor, and also the German government, have always pursued a policy of Greece staying in the euro zone... no doubts whatsoever (that the Greek situation would be brought to a) successful conclusion," she said in a joint press conference with British PM Cameron.

We feel that leaders in the funding (core) European countries are preparing themselves to make compromises should Syriza form a coalition in the Greek parliament after the 25 January elections. Compromises would include the terms of Greece's bailout packages in which the ailing nation would receive tranches of money from the IMF/EU in return promising to make good on its word to undertake painful fiscal reforms which involves deep austerity measures. Again, it is all a wait and see game for now until elections draw closer and politicians reveal more of their cards. In the meantime, we can look forward to even more whiplash in jawboning from both sides.

Germany is leaving the door open to discussing debt relief with Greece’s next government, lawmakers in Chancellor Angela Merkel’s coalition said, signaling a more flexible stance than her administration has taken publicly.

While writing off Greek debt isn’t on the table, talks on easing the repayment terms on aid that Greece received from European governments are possible after the country’s parliamentary elections on Jan. 25, the lawmakers from Germany’s two biggest governing parties said. The condition is that Greece sticks to its austerity commitments, they said.
— Bloomberg

In any case, we feel the chances of a Grexit are remote, but markets are apparently not taking this view and have been increasingly pricing in a negative outcome from a potential victory of Syriza.

 10 year GGBs are now yielding north of 10% and are en route to 11%,  reminiscent of the debt restructuring saga of 2011 . Prices have likewise tumbled to lows not seen since November 2013

10 year GGBs are now yielding north of 10% and are en route to 11%, reminiscent of the debt restructuring saga of 2011. Prices have likewise tumbled to lows not seen since November 2013

 The timeline highlighting key event risks pertaining to Greece's upcoming parliamentary elections which entails a potential Syriza majority.  The full timeline narrative of this episode can be found in our previous update

The timeline highlighting key event risks pertaining to Greece's upcoming parliamentary elections which entails a potential Syriza majority. The full timeline narrative of this episode can be found in our previous update

Besides the Euro, which has fallen more than 400 pips against the dollar, tanking through 1.2 to a low of 1.1809 seen on Wednesday after official CPI figures point to the first deflation in the EU since 2009. More on the Euro later.

Greek stocks (ASE index) have also been tumbling and have seen absolutely no reprieve from the capitulation and panic which have griped investors with fear; rotating them into safe havens in European markets such as German Bunds and Swiss bonds.

  An Alco survey to be published in the To Pontiki newspaper on Thursday showed the radical leftist Syriza, which opposes Greece's international bailout program, would win a  33.8%  share of the vote if elections were held now, ahead of Samaras's New Democracy party, which would take  30.5%

An Alco survey to be published in the To Pontiki newspaper on Thursday showed the radical leftist Syriza, which opposes Greece's international bailout program, would win a 33.8% share of the vote if elections were held now, ahead of Samaras's New Democracy party, which would take 30.5%

Several European talking heads are our trying to calm the turbulent waters with Germany's Michael Fuchs (Chancellor Angela Merkel's close aide) iterating the Greece is now "systemically is not relevant anymore". However, despite all efforts to placate European risk markets, traders are warnings against catching the falling knife; which in layman means not picking a bottom in the fire sale.

As we mentioned last week, the key date to mark down is 25 January 2015; this is the day the Greek population votes on who and which parties get seated in the 300-seat Greek parliament which is currently non existent after having been dissolved after Prime Minister Antonis Samaras failed for the third and final time to get enough backing for his presidential candidate.

Consensus is that Syriza will win the largest share of votes amongst the parties but not enough to declare a watershed victory. This is not news as we have stated before in our previous market update:

After the polls have closed, the party with a majority of the 300 parliamentary seats (at least 150 seats) will be mandated to form a cabinet to which will be sworn in 3 days after the elections. That is of course assuming matters are simple, and that one party manages to secure at least 150 seats. In reality of course, there is hardly ever a majority in a political climate as dichotomous as it is in Greece.
In the absence of a majority, the party with the most seats will be handed a mandate by the President to form a coalition government, and thereafter present the coalition for the parliament's approval. In the event that the parliament rejects the first coalition, the mandate will be handed over to the second most major party. The cycle continues down the line until a coalition is formed and approved. Depending on the formation of parliament, analysts reckon that this could possible be a protracted event extending for weeks if not months if Greek politicians choose to haggle over spilled Drachmas. Each cycle extends for the same 3-day period.
However, if no party is able for form a coalition (there are 7 parties altogether) as was in 2012, parties meet with president to try and form a coalition. If that too fails, new elections are held and the cycle extends rather painstakingly.

Although Syriza has itself said that it does not intend for a Greek departure even if it gains a majority in parliament, Germany appears to us to have gone the direct opposite way pouring fuel on an already ardent fire. As the German Tabloid Newspaper Bild reports, Germany has been preparing contingency plans in the case of a Greek departure, which includes a possible run on banks - implying that Germany actually expects such a negative outcome to unfold.

As usual, we turn to Bloomberg for more color:

Any political turmoil in Greece following this month’s election is no longer a threat to the wider stability of the euro area, Michael Fuchs, a senior lawmaker from Chancellor Angela Merkel’s party, said today.

“The situation in Europe has changed very much” since the height of the region’s debt crisis, Fuchs said today in an interview with Bloomberg Television. “Systemically they are not relevant anymore, the Greek people, so I’m not afraid for any other country.”

Pierre Moscovici, the European Commissioner for the Economy and Taxation, said in an interview in the World , that “we must let the Greeks make their choice “ in the early parliamentary elections of January 25, and that “ whatever their choice, it will be respected. It’s not up to us to choose , to ostracize, the leader of a country of the European Union.”

Mr. Moscovici, “we must make this election for what they are: an appointment you very meaningful democratic but not the possible trigger of a crisis “ . It ensures that “the situation of uncertainty created by the elections causes movements very limited in scope and volume as regards the markets. Even more, in the case of capital.”

A debt write off will cost Germany 40 billion, but a Grexit will cost 76 billion euros.

Economist Jens Boysen-Hogrefe is member of the Kiel Institute for the World Economy (IfW), an economics research center and think tank located in Northern Germany.

By a Greek haircut the German state budget would suffer greatly. Financial expert, Jens Boysen-Hogrefe estimates the potential losses for Germany, one of the main creditors of Athens, will be up to 40 billion euros, should Athens insists on a haircut, that would sink its debt ratio from current 175% to 90%.

If Greece does not serves its debt anymore, the cost would be even higher, notes the FAZ, adding that another Institute for Economic Research, the Ifo Institute calculates the cost of a Grexit as much higher.

The Ifo Institute has added further costs that would be incurred if Greece not only goes for a haircut, but it exists the euro (“Grexit”).

“If Greece becomes insolvent and leaves the euro, the Federal Republic would expect a loss of up to 76 billion euros,” said economics professor Timo Wollmershäuser from the Ifo Institute for Economic Research.
— Bloomberg, KeepTalkingGreece, Lemonde.fr
 Target2 balances of the 10 largest countries of the Euro Zone. Germany's surplus peaked at over   €750bn in 3Q12  and has since trended lower after  the nadir of the European Sovereign Debt Crisis in 2012 where Germany was the last sovereign lender of resort for the PIIGS nations. Spain still bears the largest deficit almost tying in with Italy while Greece's sits marginal close to balance due to the small size of its economy

Target2 balances of the 10 largest countries of the Euro Zone. Germany's surplus peaked at over €750bn in 3Q12 and has since trended lower after the nadir of the European Sovereign Debt Crisis in 2012 where Germany was the last sovereign lender of resort for the PIIGS nations. Spain still bears the largest deficit almost tying in with Italy while Greece's sits marginal close to balance due to the small size of its economy

Readers might be curious on why the sudden u-turn in policy on the German side. Well, it should come to no big surprise when the question of "who's the biggest looser" if a Grexit materializes. Without drilling too deep into our brains, a cursory run-through of our past commentary reveals that it is Germany that will collectively loose the most should Greece leave. In other words, the nation who should logically be most opposed to a Grexit is none other than Germany. Just by looking at the Target2 balances within the Euro Zone, one realizes that Germany has been the largest creditor to just about all of peripheral Europe.

 Bloomberg:  The nominal amounts at stake do illustrate the  motives for German resistance to restructuring . Yet a more relevant measure would adjust for a  country's ability to absorb those losses . The picture radically changes when that exposure is expressed as a share of 2013 nominal GDP. On this ranking,  Germany falls to No. 9 with an exposure amounting to 2.2 percent of its economy's size . France falls to No. 8 (2.2 percent) and Italy to No. 7 (2.5 percent). Portugal (3.2 percent), Cyprus (2.8 percent) and  Slovenia (2.6 percent) top the ranking , meaning these countries have the  most to lose  if Greece decides to write down its public debt

Bloomberg: The nominal amounts at stake do illustrate the motives for German resistance to restructuring. Yet a more relevant measure would adjust for a country's ability to absorb those losses. The picture radically changes when that exposure is expressed as a share of 2013 nominal GDP. On this ranking, Germany falls to No. 9 with an exposure amounting to 2.2 percent of its economy's size. France falls to No. 8 (2.2 percent) and Italy to No. 7 (2.5 percent). Portugal (3.2 percent), Cyprus (2.8 percent) and Slovenia (2.6 percent) top the ranking, meaning these countries have the most to lose if Greece decides to write down its public debt

Other than internal Target2 imbalances, we should also factor in native exposure to GGBs and corporate debt of Greek banks most of whom remain in flaccid financial health. Turns out, other than the Italian banks, Germany (the largest creditor in the 62% portion pointed out below) has the single largest exposure to GGBs as Bloomberg points out in its briefs:

"Who owns Greece's public debt? That's the 322 billion-euro question, according to the Finance Ministry's figures from the third quarter of last year. Most of the debt has changed hands since a bailout in 2010, a second in 2012 and a restructuring involving private creditors that same year. Private owners now hold only 17 percent. The secondary market has become very thin — bear that in mind when looking at 10-year bond yields. ... A default would have to be absorbed instead by official creditors, holding the remaining 83 percent of outstanding loans and bonds. These include euro-area governments (62 percent), the International Monetary Fund (10 percent) through its participation in the two bailouts, and the European Central Bank (8 percent), which purchased bonds in 2010 through its Securities Market Program. The remaining 3 percent are repurchase agreements and assets held by the Central Bank of Greece. It is unclear where losses on that portion would fall."

We hope this serves as a good primer when our readers chance upon any article that panders to a Grexit scenario and that Germany is fine (politically and financially) with such an outcome. The above 2 charts have dealt the heavy punch to the chin of such an outrageous claim. This is the prime reason why we do not foresee a Grexit; the other is because we have seen many similar flares revolving around such controversial topics that we have grown accustomed to it.


Deflation Strikes Europe For The First Time Since 2009

We have been warning readers, since we started going public with our commentary (see here, here, here, here, and here), that the real risk the world (and especially Europe and Japan) faces isn't inflation but deflation. We presented many market-based points of evidence (including inflation breakevens) that suggested that deflation was indeed the juggernaut that will eventually wreck havoc on major developed economies plainly because so many people (including policy makers and government ministers) choose to believe that a deflationary outcome was impossible, and lived a life in denial due to the illusion that quantitative easing had done its job of jacking up prices.

 This chart courtesy of Zerohedge, illustrates how the Euro Zone just slipped into the twilight zone of deflation; and it didn't do so with a whimper but instead nose-dived under 0% from November's 0.3%. This comes on the heels of Draghi's comments on launching sovereign QE

This chart courtesy of Zerohedge, illustrates how the Euro Zone just slipped into the twilight zone of deflation; and it didn't do so with a whimper but instead nose-dived under 0% from November's 0.3%. This comes on the heels of Draghi's comments on launching sovereign QE

It turns out that we and a few others had been dead on right about our warnings. Not that we feel good about that, but it serves as a good reminder to disregard marker indications at your own peril. The hubris of the powers that be have got the better of them this time.

One might have thought that the Euro should have seen some dearth of selling after the u-turn in German-Greek rhetoric but the markets were then presented with a -0.2% annualized CPI growth rate for December 2014, on expectations of a -0.1% print. European equities were heavily offered after better than expected employment data from Germany which showed that Europe's largest economy added a total of 27,000 jobs against expectations of an addition of 6,000 jobs, pushing its unemployment rate to a record low of 6.5% from November's 6.6%. On the flip side, unemployment in Italy continues to rise to a record high of 13.4% in December, on expectations of an unchanged 13.3% in November. The bifurcation is still well and alive in the single currency union it seems.

 According to the WSJ, most Asian economies (and emerging markets) stand to benefit from weaker energy prices. They stand to benefit from lower inflation pressures and enjoy better trade balances in the process. This doesn't however take into account the negative contagion effects off an negative oil price shock

According to the WSJ, most Asian economies (and emerging markets) stand to benefit from weaker energy prices. They stand to benefit from lower inflation pressures and enjoy better trade balances in the process. This doesn't however take into account the negative contagion effects off an negative oil price shock

 A simple example of negative contagion within the American market is depicted as market performances have been nothing short of ugly for these companies that produce sand used in fracking (hydraulic fracturing) for American shale-oil drillers

A simple example of negative contagion within the American market is depicted as market performances have been nothing short of ugly for these companies that produce sand used in fracking (hydraulic fracturing) for American shale-oil drillers

The terrible price data from the Euro Zone has been mainly blamed on falling energy prices and weaker growth expectations. Indeed, North Sea Brent broke under $50 while the WTI-Brent spread narrowed to $2.50 at its tightest, something not seen often and indicates the ferocity in oil's price swings. Following Europe's deflationary data, 10 year Germany Bunds traded at a new record low yield as the periphery-core rotation coupled with outright deflation continue to force funds into the safety of safe havens. The ECB's NIRP (negative interest rate policy) is also acting as a strong wind behind the back of this flow.

As we mentioned earlier, many European politicians blindly remain in denial when it comes to deflation risks. This excerpt of a dialogue between a slightly skeptical journalist and the ECB's Constancio proves just how full these fellas are with hubris:

 The Baker Hughes oil rig count has continued to tumble at an accelerating pace to  1811 rigs last week, down by 109 rigs from the previous week . This illustrates the point we have been harping on, namely that   lower oil prices are just part of Saudi Arabia's secular strategy to crowd out new entrants of US shale-oil producers, and especially those with high breakeven costs

The Baker Hughes oil rig count has continued to tumble at an accelerating pace to 1811 rigs last week, down by 109 rigs from the previous week. This illustrates the point we have been harping on, namely that lower oil prices are just part of Saudi Arabia's secular strategy to crowd out new entrants of US shale-oil producers, and especially those with high breakeven costs

Journalist: My question would be on how credible these tests are. Looking at the adverse scenario, you haven't even included deflation. You have not included an interruption in gas imports to Europe. You have not included full-on sanctions on Russia. So please elaborate and convince us.

Constâncio: The scenario for the stress test was published earlier in the year, so some of the things you mentioned would not have been considered. But indeed, what was considered is a severe shock being the growth of other countries. If you look to the scenario, you see that for the US, there is also a big deceleration of growth which is part of the scenario and also for other countries that are the markets of the euro area. So that is embedded in those assumptions of indeed a big drop in external demand directed to the euro area. That's the first point. The scenario of deflation is not there because indeed we don't consider that deflation is going to happen.

We do not expect the ECB to embark on sovereign QE at this juncture, at least not with the Greek elections as a major wildcard. However with that being said, we do expect yesterday's deflationary prices to put much more pressure on the Governing Council to increase not only the scale of purchases but the breadth of securities including in its bond buying program.

We are reserved to making further comments, but from what markets are signaling, it seems the ECB would soon need to fold and begin purchasing sovereign bonds, much to the chagrin of Germany's Bundesbank and other rightists. But until then, don't hold your breaths.