Market Rumours

Beware of Greeks bearing gifts. It's an overwrought cliche, but one that bond investors should reflect on if Greece woos them with a new 10-year bond in coming days. History suggests the Greek government's pledge to overcome its debt crisis by slashing its gaping fiscal deficit could prove to be a Trojan horse like the one from which the saying comes. As University of Maryland professor Carmen Reinhart and her Harvard-based co-author Kenneth Rogoff point out, Greece has spent half of its time since its 1830 independence in default. In their studies of such "serial defaulter" countries, the two economists demonstrate that such countries typically fall victim to a vicious cycle of declining market confidence, political paralysis and economic malaise that often makes default inevitable. In fact, Greece's situation--its fiscal deficit at 12.7% of gross domestic product, its total debt at 113% of GDP, the strong euro's squeeze on its competitiveness--looks alarmingly like that of fellow serial defaulter Argentina before its record-breaking $100 billion default in 2001. The one thing saving Greece from Argentina's fate is its euro-zone membership, which creates an incentive to avoid a blowup. If Greece were to dump the euro, its financing costs would be far higher than the three-and-a-half-percentage-point spread its bonds currently pay over comparable German bunds. Meanwhile, the European Union is worried about domino effects hitting bigger heavily indebted sovereigns such as Spain and Portugal or Europe's already shaky banks. That's why the market expects the EU--or specifically, Germany--to eventually come to Greece's rescue. Investors have been encouraged over the past two weeks by Greek Prime Minister George Papandreou's promise to implement his austerity plan by March 15 and by indications of EU willingness to lend money if necessary--albeit formulated in vague terms. But while its yield spreads have narrowed--and those on Spanish, Irish and Portuguese bonds even considerably more--the market will continue demanding a wide premium on Greece's debt. Getting its fiscal house in order isn't going to be easy. For one, the belt-tightening plan risks creating a negative economic and political feedback loop. Earlier Tuesday, Fitch Ratings downgraded the four biggest Greek banks on concern that spending cuts will hurt the economy and lead to a deterioration in their loan books. Ultimately, whether there's a default "is a decision that Greece itself will make," says Brian Yelvington, director of fixed-income research at Knight Libertas. "Will the political powers accept the conditions that Germany is likely to put on this assistance?" Political will isn't something Greek governments are known for--hence the history of default. With Greece's powerful unions staging a general strike to protest the austerity plan this week, this political fragility has been brought into stark relief. Germany is politically constrained, too. The euro-zone heavyweight has a strong interest in helping Greece avoid a default--to prevent a blow to its banks and preserve the integrity of the monetary union. But its taxpayers will balk at guaranteeing Greek debt, especially if it sets a precedent upon which Portugal, Spain, Ireland or Italy might one day call. German policy makers face a similar dilemma to that which U.S. officials grappled with when deciding whether to bail out U.S. financial institutions during the crisis of 2008. Yet theirs is even more problematic. "The American economy ultimately has the ability to recoup [those bailout costs] by taxing all of its members," says Knight's Yelvington. But "Germany does not have the ability, necessarily, to recoup its losses on loans to Greece. It will be taxing its own taxpayers to cover that and putting its own economy in a state of fiscal peril." Faced with such complications, Greek yield spreads aren't likely to come in much further in a hurry.

If a new UK government were to cut spending too hard and too fast, "it would not be hard to envisage the pound falling quickly back to its mid-1980s low of 1.05 against the dollar," says UBS. Investors "would question the government's ability to pay back its bonds if the economy starts to contract again," it adds. Bank is short GBP/USD, targeting 1.50, but based only on the BOE's "admirable" stance of keeping QE options open. Now trades at 1.5453.

Mizuho Research Institute economist Atsushi Matsumoto says Japan's better-than-expected January export data (+40.9% on-year vs +36.4% expected) "confirm the nation's shipments will remain strong for months ahead thanks to demand related to enriching infrastructure in Asian countries." Despite government's monthly report yesterday cutting exports' view to "increasing moderately" from "increasing" in February, Matsumoto optimistic about outlook. "The government judged conditions of exports by looking at December's data. But January's data just proved exports are gaining momentum again." Adds, Toyota recall wouldn't be big problem for economy for now, though careful monitoring of development necessary. "I don't think the issue will weigh on exports for the time being, but if Toyota handles Congressional hearings inappropriately, the firm may be forced to cut their production. That will have a certain negative impact on the Japanese economy," he says. Analysts say shipments of cars and car-related products account for about 15% of total exports in 2009.

USD/JPY likely to be supported by Fed Bernanke's semi-annual testimony even if he doesn't signal near-term rate hike, says Barclays Capital chief FX strategist Japan Masafumi Yamamoto. "Step by step, the Fed is going to get closer to an exit, which will decrease the dollar's liquidity anyway. That's positive for the dollar in the longer term." Adds Japan trust funds likely to sell "as much as Y1.82 trillion" of JPY later in day to open new investment trust fund accounts, known as toshin, limiting JPY's upside. But dealer close to these trust funds says amount isn't that large, expects about Y100 billion in total, most of which will be BRL-denominated; "you shouldn't expect too much from toshin for yen-weakening effects," dealer says. USD/JPY last 90.23