Greece – could all roads lead to Euro breakdown?

Takeaways: With Greece on the edge, markets have maintained remarkable poise.  Meanwhile, there’s a warning that UK interest rates might rise this summer. Another Maradona moment?   Labour markets might be ‘fizzing’, but a rate rise this summer feels premature, with echoes of the ECB’s move in 2008.

Greece – Could all roads lead to Euro breakdown?

With Greece’s €1.6 billion repayment due to the IMF at the end of the month the country risks default and a possible EU exit.  On Wednesday, the ECB increased its emergency funding for the fifth time in eight days as savers withdraw up to €1 billion a day from domestic banks. Lender demands include cutting the deficit more through spending cuts rather than tax rises; cutting pension payments rather than increases in contributions and higher VAT.

With the latest position in Greece being a moving target as the debate continues – what is this doing to the markets?

In short, the two sides are edging towards a deal, investors are comfortable that the short-term impact on the Eurozone has been neutralised and the structure of the Euro can be maintained.  European stock and bond markets are rallying. Amidst the Greek crisis, the economic recovery continues. Italian industrial orders surged 5.4% in April, the Spanish are making babies again with an uptick in the fertility rate and the Eurozone unemployment rate is shifting lower (albeit still high).  The ECB is also doing its part by printing money and boosting its balance sheet to €2.45 trillion as of last week.  Even in Germany, where the costs of supporting Greece are significant (as the old joke goes – A Greek, an Irishman and a Portuguese walk into a bar, who picks up the bill?  A German), the economy is looking good with historically low unemployment and a weak Euro supercharging exports.

Chart:  ECB balance sheet

ECB balance sheet 260615

Longer term there is a broader range of outcomes and uncertainty exists.  Some say that this could expose the flaw in the single currency. Whether Greece stays or leaves, the crucial concept of Eurozone membership – that it is irreversible- has been completely undermined.  This may leave the markets ultra-sensitive to the next political crisis.

This means next time a potentially anti-Eurozone party comes into power (or comes close) in France, Italy or Spain then investors are going to get nervous. This could come sooner than expected with Portugal having an election in the Autumn and Spain’s in December where the radical left-wing party, Podemos, are doing well in the polls. Regardless of the Greek outcome, what this ultimately comes down to is whether economic recovery in these countries progresses far enough to mitigate political risk.  Some say the Eurozone is in a race to achieve recovery before anti-establishment parties can secure support. If not, there could be some choppy times ahead for the markets.

BoE doing an ECB?

After more than six years, the Bank of England could be first past the post and interest rates could finally be on the rise in the UK. What is the catalyst for the change in sentiment? 

For the past six years, despite some stray votes and speculation that the MPC may be divided, we have seen consistency in holding rates low at 0.5%. However, Martin Weale, one of the most hawkish MPC members – now public enemy number 1 for floating rate mortgagors – believes tightening labour markets, currently “fizzing away nicely”, are likely to require a response –  even if oil prices kept inflation lower for longer.

Inflation is currently running well below the BoE’s target of 2% – at just 0.1% for the year to May. Some analysts say there is no pressure to raise rates and there also is some speculation whether the MPC are just trying to send a signal.  The central view of the MPC is however that inflation will speed back towards the 2% target during early 2016.

The markets are reacting predictably. The news has certainly crept into the money markets with Sterling continuing to strengthen, particularly against the US Dollar. It’s a trend we’ve seen throughout 2015, with speculation that the UK would be the second major central bank to raise rates, after the US Federal Reserve -aside from some pre-election volatility.  Short sterling futures also fell for Dec-15 to their lowest since early May.  UK Government bonds predictably declined, pushing yields on 2-year notes to seven month highs.

What about the UK impact?  Views are mixed. The impact on London will differ dramatically to elsewhere. Berkeley Homes said that the prospect of an interest rate rise may help ease the pressure on rising London house prices driven by a supply shortfall.  However, a recent article suggested that as many as 70% of new build houses in the capital were purchased by foreign investors – often for cash.

(If there is a problem brewing in the London property market, then short of having different interest rates between London and everywhere else in the UK, should the issue not be dealt with by addressing the excess liquidity in the market. Perhaps by requiring additional bank capital allocations against their mortgage book?)

How about further afield?  If the BoE does raise rates first – the US and Eurozone economies will receive a welcome boost as their currencies weaken against GBP.  This revelation closely follows Christine LaGarde’s (IMF) plea to the US Fed not to raise rates just yet.

The current scenario bears resemblance to the ECB’s rate hike in the face of the financial crisis back in 2008, when rates were increased, but reversed again within months as the ECB was forced to cut faster and further in order to stave off economic disaster in the wake of Lehman’s. The current crisis isn’t on this scale. However, the BoE may be unlikely to move ahead of the US Federal Reserve and, with potential volatility in the Eurozone, a rate rise before the dust settles could be another premature move.


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