EUR unfazed as Greece negotiations go to the wire

The Greek PM delivered a sour message earlier today when he said that Athens’ creditors had rejected the latest Greek proposals. After optimism about a deal helped to buoy European stock markets earlier this week, the latest news has sent the German Dax down nearly 1% so far, and Greek bond yields have also moved higher after coming off sharply earlier this week.

Interestingly, the EUR has remained steady. It actually fell on Tuesday when the outlook for a solution to Greece’s latest cash crunch looked like it could be within reach, so why is it not falling further when the negotiations look like they may have broken down?

Why is the EUR not reacting to Greece?

To answer this we need to look at the factors driving the EUR right now. The outlook for the Federal Reserve’s future policy path is the key theme in the FX market. The recent US economic data and commentary coming from some Fed officials suggest that a rate hike is possible this September, which is helping to drive short-term US yields higher and boost the USD. Greece is nowhere near as important for the FX market in our view, however it could affect the EUR in an interesting way: the carry trade.

Is the carry trade limiting EUR downside?

The sharp fall in EURUSD earlier this year, when it dipped below 1.05, along with the ECB’s QE programme, made the EUR an attractive funding currency for the carry trade – where a trader buys a currency with a high yield, and sells a currency with a low yield. The carry trade strategy works well during periods of low market volatility, but when volatility increases due to a crisis like the one that Greece is experiencing then the carry trade can find itself out of favour. Thus, when Greek pressures start to mount, this can increase pressure on volatility, triggering an unwinding of carry trades and boosting the EUR.

Due to this, we may only see limited EUR losses during the latest twist in the Greek saga, and we may have to wait for things to settle down in Athens (volatility to fall) before the EUR downtrend resumes. 1.1050 remains a critical level of support for EURUSD as we wait to hear the outcome from the latest round of Greek negotiations.

Equities – hanging on every word from Brussels  

European stock markets are a different beast, right now. They seem to be moving in lockstep with the developments in Greece, so expect equity market volatility to remain high over the next few days as we wait to see if Greece can get another deal.  If a deal is reached, then we could see some upside in European stocks, but we believe Monday’s massive 4% jump on the back of hopes for a deal may not be repeated even in the event of an official announcement that Greece has avoided default.

The market view

From a market perspective, watch out for 2-year Treasury yields. A further increase in yields could trigger another leg higher for the dollar. Dollar strength could be felt most vs. the pound and the JPY for the rest of this week as both currencies are looking vulnerable.

If you are trading the EUR or stocks then watch out for further developments in the Greece crisis including

• Any official comments from Greece’s creditors that it has rejected Athens’ proposals, this could send stocks lower and also knock the EUR.
• The outcome of the Eurogroup meeting – officials have said that a decision on whether to extend funds to Athens needs to be made today.
• Tomorrow looks like the latest D-day – if a decision is not made then will the can be kicked down the road once more, or will Greece be cut lose and left to default?
• Will the ECB keep extending ELA funds to Greek banks? If not then it could be game over for Greece.

It will be an interesting 48 hours for the Greek crisis, but don’t expect a textbook reaction from the single currency, whatever the outcome.