World markets themes ‘coming week’
The Greek government will have to push its latest austerity package through parliament in the coming week to release the next tranche of bailout money that it needs to pay coupon, redemption payments due in July.
But that alone will not be enough to convince financial markets of the sustainability of its fiscal position. Bond prices and CDS reflect investors' scepticism about whether Greece can meet the tax revenue and privatisation targets on which future IMF/EU disbursements are predicated, even if Athens receives the funding it needs in July.
A restive electorate will make it hard for the government to push through new austerity measures at speed, leaving the threat of an eventual default hanging over the market.
The vicious cycle of contagion to the rest of the periphery is also evident. Portugal's 10-year bond yield has jumped nearly 2 percentage points in June and its CDS curve has sharply inverted, signalling the high risk of a credit event in the next two years.
Even Spain is seen as not completely out of the woods, with the IMF saying the country faces risks to economic recovery and must deepen and conclude reform work to reassure markets.
Any relief rally that would be triggered if the July 3 Eurogroup meeting agrees to release the next tranche of aid may therefore prove short-lived, especially given question marks over how private bondholders will share the burden of aiding Greece without triggering ructions in financial markets from ratings downgrades.
European financial institutions are in consultation with their governments about how any private sector involvement in a second Greek bailout might work.
A rollover of bonds at maturity is one of the central scenarios under discussion, but the devil will be in the details of the terms. European politicians want a solution that will buy time for Greece and avoid short-term contagion
But they must also take into account the need to avoid a credit event, as the ECB has stipulated. While there have been some signs of stress in money markets and ECB President Trichet has warned about the risks to financial stability, a few analysts (including those at Citigroup) are suggesting shares in core European banks have been oversold and offer a buying opportunity.
Event risks in the coming week may in the short term make this a trading idea only for those with strong nerves and equally strong convictions.
The deepening Greek debt crisis and tepid manufacturing activity data from some euro zone countries have raised questions about whether the European Central Bank will push ahead with the monetary tightening it flagged in the wake of its meeting earlier this month.
Flash euro zone inflation data for June due on Thursday could put an end to such speculation if it shows no easing in price pressures. If this is the case, German bonds will remain the subject of a tug of war between safe-haven demand stemming from investors' concern about the peripheral euro zone debt and their reluctance to buy such low-yielding debt at a time when ECB rates will rise.
Two-year German debt is yielding less than 1.5 percent, the level to which the refi rate would rise if the ECB were to tighten policy in July. Moreover, market chatter that the Bank of England might consider extending its asset purchase programme to support a fragile economic recovery is bound to ensure German Bunds continue to underperform UK gilts and keep sterling under pressure.
The euro has weathered the euro zone sovereign debt crisis without ceding too much ground recently and is, in fact, nearly 6 percent higher against the dollar in the year to date and about 3.5 percent higher on an ECB trade-weighted measure.
Asian central banks' continual needed to recycle the dollar proceeds of their interventions and the divergent interest rate outlook between the euro zone and the United States have lent vital support to the single currency so far.
Still, the timetable for new aid for Greece in July to avoid a default is tight and concern about the euro's outlook continues to be flagged by the FX options market, where implied volatility is holding firm and there is still a hefty premium on options that give the holder the right to sell euros rather than the right to buy. > Rolling report on major currencies
Investors have been shifting money out of stocks and definitely out of European equity markets, which are on track for the longest run of weekly losses since 1998.
The negative yield offered at one point this week on one- and three-month US Treasury bills is an indication of where some of that money has headed.
Still, if the ebb and flow of money parked in zero-yielding cash is any signal of the level of concern about the financial world at large there is so far, at least no stampede of investors running for cover, despite ECB officials' warnings about the risks to financial stability. Figures on money market funds show the net outflow is more than $100 billion for the year to date. Any collective panic in the investment community will show up as a week by week reversal of this broader trend.
Copyright Reuters, 2011