Potential deal in Greece, Speculation on Danish peg and US interest rates

No story is really dominating headlines today. So I thought it would be a good time to look around at a number of different topics I have written on in the past. Of course, Greece is still the biggest issue but it is optimism today instead of pessimism that has the markets’ attention.

The latest I have heard is that the Athens Stock Exchange was up 6.4% and banks up 14.4% on the rumour that a deal could be reached in the Greek debt impasse. The European Commission has said that no formal proposal is on the table but talks are intensive. Today and tomorrow are important because the Eurogroup finance ministers meet tomorrow, where Greece will present its definitive proposal to avoid a default.

The following synopsis from the Irish Independent and comment from ING Capital sums up the situation best in my view:

The Greek government and Eurozone leaders have struck a defiant tone, with Mr Tsipras insisting his country would not extend its bailout and Germany saying it would get no more money without such a programme.

Eurogroup chair Jeroen Dijsselbloem has ruled out providing Greece with a bridging loan to keep the country afloat while it renegotiates the terms of its bailout.

Gary Jenkins, chief credit strategist with ING Capital, said the risk of a so-called ‘Grexit’ has now increased from 35pc to 50pc.

“It seems nonsensical that Greece could end up leaving the Eurozone because they could not agree with their European partners on the best way to get through the next few weeks to allow them to spend time negotiating, but that is a realistic possibility,” he said.

Now, one could make the argument that this is just posturing still. I tend to think we have gone beyond the posturing stage at this point and we are now hammering out a deal under an intensely stressful timetable. At a minimum, you would think you could get some sort of deal through to extend the timetable. But trust is in short supply here and the EC has been caught off-guard by how tenaciously Syriza has held to their election promises. Policy error is definitely possible.

Moody’s downgraded some Greek banks just yesterday to Caa2 from Caa1 and some more from Caa2 to Caa3, with a negative outlook. If we do not see a deal, the likelihood of the ECB pulling out authorization for Emergency Liquidity Assistance to Greek banks and a bank run is high. At that point, you have to impose capital controls and then a eurozone exit would be feasible.

In Denmark, the speculative attack against the Danish peg continues despite 4 rate cuts in three weeks to penalize deposit balances. After the last cut the Danish central bank head said, “Either we can expand our balance sheet or we can go deeper into negative territory with the interest rates. That is a possibility and no one should try to outguess us here.”  But they are trying to outguess him.

The problem for Denmark is that this a classic asymmetric speculative payoff situation. A tax of 1 or 2% pro-rated for just a few weeks is simply not enough to deter speculators from moving into your currency if they can win 20, 30 or 40% overnight as they did in Switzerland. The Danes will be forced to print money and lots of it. Moreover, it isn’t clear what the ECB can do to help here. The ECB should give moral support in the form of a clear statement that it will do whatever it takes to stand by its partner in Denmark because of its legal obligation under the European exchange rate mechanism to do so. But in terms of concrete steps it can take to back up that statement, we are at an impasse because the ECB cannot create Krone. It could only into a forward swap arrangement with the Danes to sell Krona in unlimited amounts at a fixed amount. And then we’d have to see what impact this would have on speculation against the Danish currency.

For me, the situation calls two things to mind. First, there is the ERM I attack on Britain, Italy and Sweden from 1992 where Sweden raised short term interest rates to 500% before allowing the peg to collapse. All three countries were ejected from ERM and only Italy re-joined subsequently, to their great regret I reckon. In the last case, had their been an ECB, it could have been forceful in selling euros to help defend the peg since it can print euros. But when the peg is under upward pressure, the onus falls on the central bank of the pegged currency, meaning the difference between Denmark and Switzerland is less significant than the ECB backstop would have us believe.

Then there is the fact that there is this upward pressure. It says to me that a Greek eurozone exit would be an event that would put upward pressure on the euro, not downward pressure. I know some pundits are saying the euro could collapse to 90 cents if Greece exited the eurozone. But why? The only reason is short-term in terms of QE to defend the rest of the periphery. But after that, speculation about other departures would begin, especially given the deflation that is taking hold. I see a Greek exit as a catastrophe for Europe that will put more pressure on a currency union that is barely able to contend with the existing debt deflationary forces. We shall see.

In the US, I think Tim Duy has a good read on the Fed. Right now, the Fed has a credibility gap as markets simply do not believe it will hike as aggressively as it says it will. But, there is one big point here. It is that the Swiss/euro floor debacle taught markets that forward guidance is a sham as a policy tool. Time inconsistency means a central bank will react to data and retract forward guidance. And so it behooves market players to front-run those moves. 

What the market is telling the Fed right now is that hiking would be a mistake, that it would potentially invert the yield curve and turn what right now seems to be an economic expansion with more legs to it into something headed for an end of cycle downturn. Personally, I think it would be dangerous for the Fed to ignore that signal and hike rates in a way that created yield curve inversion.

Here’s the scary part though: the market could be pricing in secular stagnation as the norm going forward – a Japanese outcome. And this means that rates will continue to stay low. The way I have expressed this in the past is by remarking that the natural rate for a zero-day fiat currency liability is zero. “Let’s step back and ask ourselves: what is the functional difference for a fiat-currency issuing government between bonds and bank notes? Both are liabilities of government. But liabilities of what? The only obligation they enforce on government is a promise to repay with more paper (or electronic bank credits, if you will). Or as the ten pound note says “I promise to pay the bearer on demand the sum of ten pounds.” For all intents and purposes, bank notes, reserve deposits, and Treasury securities are fungible: they are obligations to be repaid in the same fiat currency – a token representing a claim backed by the sovereign government’s authority to tax in perpetuity and to ban all other forms of payment in its domain and for tax repayment. The natural rate of interest on these tokens for zero-day liabilities is exactly zero. The sovereign government has no obligation to recompense any holder of its liabilities with any interest whatsoever.”

Tim Duy puts it this way:

I suspect there will be disbelief if not outright hostility to the idea that equilibrium short term real rates are near zero. Monetary policy makers will not like the result because it implies a narrow range to the effectiveness of their interest rate tools. They will also fear the asset bubble implications; many market participants will lament the same. I understand. That those in the rentier business would be hostile to the euthanasia of the rentier is expected and understandable. But if (safe) real returns are indeed collapsing toward zero, then obtaining higher returns will require taking on more risk, and more of those in the rentier business using more money to chase more risk will undoubtedly yield more asset bubbles of one variety or another. Those entrusted with financial stability will counter with a more costly regulatory environment to limit the creation of those bubbles, thereby making the rentier business even more difficult. In short, the future looks challenging for the rentier business.

If secular stagnation is true. Zero short rates will anchor long rates and the yield curve will flatten over time. Some people might think this is a boon for risk assets. Japan shows you that it isn’t for several reasons:

  • low nominal GDP environments make debt burdens more onerous and increase the tendency to deleverage at cycle troughs
  • low fixed income returns from flat yield curves anchored at zero increase pension liabilities by increasing the net present value of future payouts while decreasing fixed income returns.
  • profit growth in low nominal GDP environments is weak. And this is very important for equities. Even if the discount rate is permanently lower, so too is earnings growth. In an environment in which bouts of deleveraging are greater and earnings volatility and corporate distress higher as a result, this speaks to lower P/E ratios, not higher. This is what Japan teaches us about secular stagnation.

It would be good to know what is driving secular stagnation in Japan to figure out why it seems to be coming to North America and Europe. But I don’t think we’re there yet. I have some opinions on this regarding income distribution and private debt overhangs but dealing with these issues is a redistributive solution which  ‘creditors’ will fight hard against. Thus, if we are being set up for secular stagnation, we should expect a slow grind via the euthanasia of the rentier and the reversion of p/e ratios to the mean and below.

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