Market Analysis For January 6, 2015

Greek risk rises while Crude Oil, commodities fall: The market has been quite blasé about the risk of Greece leaving the eurozone (the “Grexit”) after the coming election, but that risk came into focus yesterday after the German magazine Der Spiegel said that “Chancellor Angela Merkel is willing to accept a "Grexit" should a new leftist government in Athens demand concessions.” The story was denied all around in the halls of power in Germany and Brussels, where it was argued that Greece is in the eurozone to stay.

However, the idea of a Grexit is getting a lot of boost from Greek PM Samaras, who is trying to scare people into voting for his party by warning that a vote for the opposition SYRIZA coalition would mean leaving the euro.

In any event, the election seems up in the air. Recent polls suggest neither Samaras’ New Democracy Party nor SYRIZA is likely to get a majority, meaning either a coalition or even another vote will be necessary. It seems to me that the uncertainty is likely to continue even past the Jan. 25th election and that this is likely to continue to put pressure on the euro.

For example, it’s unclear whether the ECB can institute quantitative easing while the Greek government is negotiating over its debt. That could hit confidence in the eurozone and a further exit from European assets. The Euro Stoxx was down 3.7% yesterday, with energy and mining shares the worst hit, while eurozone bond yields, both core and peripheral, moved higher. Where did the money go to? Probably out of the euro, is my guess.

The market is clearly less concerned about a Grexit than it was last time the issue came up in 2012. That’s because most of Greek debt is now in official hands, not the private sector, and there are more programs in place to deal with such disruption, like the ECB’s Outright Monetary Transactions plans.

On the other hand, the fact that the latest Greek crisis has occurred even while the Greek economy has finally started improving and the government has achieved a primary budget surplus is a warning that other troubled peripheral countries can’t be complacent. Finally, although there are more programs in place to deal with market disruption in case of Grexit, these plans have never been tested, nor is there enough money backing them if the crisis should spread to a large country like Italy. In short, the Greek crisis is likely to hurt sentiment towards the euro until and even after the election, in my view.

USD weakened yesterday nonetheless on what seems to have been profit-taking on the recent swift move. Further declines in Fed Funds rate expectations and falling bond yields as commodities fell (see below) may also have weakened the currency. I expect the dollar’s weakness will only be temporary though and I think if anything it simply sets up more attractive entry levels for long dollar positions.

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GBP was the exception among G10 currencies as it weakened vs USD following a disappointing construction sector PMI. This strikes me as ridiculous. The PMI fell to 56.7 in December from 59.4, vs a consensus estimate of 59.0. But what is the PMI? Basically, it is the percent of people saying conditions are improving minus the percentage who say conditions are worsening. Conditions can’t improve indefinitely. Eventually conditions will be the same one month to the next, and the PMI will fall. But that doesn’t mean things are bad. In any event, 57.6 is far above the long-run average of 54.5 and still signals strong expansion. With oil prices falling and inflation nearing zero, UK growth looks likely to continue robust and I would expect GBP to gain vs euro, although probably not vs USD.

Commodities were generally weaker yesterday, led by oil. Oil prices continued to fall as Russia production hit a post-Soviet record, Iraq's oil exports in December were the highest since 1980, and Saudi Aramco cut the official selling price for its Arab Light crude to Northwest Europe. No wonder then that RUB was off around 2%! One major oil sand producer in Canada noted that production in Dec was down 14% mom, another reason to be bearish USD/CAD. China increased export tax rebates for some copper products in a move that’s expected to increase demand for copper. Nonetheless, copper prices fell 1.3%, which shows just how weak demand is. On the other hand, the Chinese government scrapped an export tax rebate on some steel products, which sent iron ore futures lower – a potentially AUD-negative development.