Fed trumps Greece as dollar tumble continues

Looking at the FX market you wouldn’t think that European officials are heading into an historical meeting that could decide the long-term fate of Greece. EURUSD has been hovering around 1.14 for most of this morning after reaching a high of 1.1420. EUR strength comes after the Fed’s meeting was considered dovish, even though the FOMC are clinging onto the prospect of two rate hikes this year.

The fact that Yellen wasn’t willing to hint at a September rate hike, instead saying that a potential hike would only be data dependent, was enough for investors to dump the dollar and give stock markets a boost, it has even been enough to ease Greek fears and boost the EUR. But for how long can this last?

The spot market may be sanguine, but it’s hedging its bets …

It has already been noted that there is an anomaly going on in the FX market, with the spot market relatively sanguine on the prospect of a Greek default and European exit, in contrast to the options market where 1-month EURUSD volatility has been hitting fresh highs. This suggests that the market still expects an 11th hour (or maybe 12^th hour at this stage) deal to give Greece a few more months of respite and is thus willing to ignore the alarming headlines coming from both Athens and its creditors. However, just in case the trigger on Greece is pulled, the FX market is hedging its bets, hence the rise in EURUSD volatility.

Don’t expect any 11^th hour solutions

Today’s Eurogroup meeting is being heralded as the last ditch attempt for Greece to appease its creditors and win more bailout funds. We expect this meeting to last a little longer than Sunday’s, which was abandoned 45 minutes into negotiations, however we don’t hold out much hope for a resolution.

It appears that the writing is on the wall for Greece, especially after the Bank of Greece said that its country would run out of money at the end of this month. The Bank issued a catastrophic warning saying that unemployment would rise and a deep recession would ensue if Greece defaults, which would take the country out of the core of Europe and relegate it to the “rank of a poor country in the European south”. Even former Greek Ally, EU Commission President Jean Claude Juncker, said he has lost faith in the Syriza government.

More political than financial…

The social impact will no doubt be catastrophic for the Southern European country and the political fall out huge. Greece may even lose its Russian connections who most likely would prefer Athens to remain in the Eurozone to try and put pressure on the authorities to bring an end to EU sanctions on Moscow. However the market impact could be limited in the longer term for a few reasons:

• The market has had time to prepare for a Grexit, so it unlikely to come as shock to investors.
• Private investment in Greece has dramatically fallen since the onset of this crisis. Official public bodies like the IMF and ECB are likely to be the biggest losers, not private investors, which would also limit market panic.
• Greece’s government stance has been extreme, and no other European nation is currently in a similar situation, which could limit both financial and political contagion effects.
• We would note that other peripheral European nations have not seen a notable rise in bond yields in the months leading up to this moment. Spanish 10-year yields are still only 2.24% and have dropped 10 basis points as we lead up to this afternoon’s Eurogroup meeting.

Overall, we don’t see Greece as being a long-term issue for financial markets.  On  the official announcement of a default we could see risk aversion take hold, stocks are already selling off, however, we think this could be temporary. As long as the EUR doesn’t embark on a long-term uptrend, which could hurt the Eurozone’s tentative economic recovery, we continue to think that European bourses can benefit from the ECB’s QE programme and may continue to outperform their US counterparts later this year.

EUR on your way out Greece…

As we mention above, the single currency remains remarkably tolerant of the events in Greece. In our view this is because the chief driver of FX is yields, not politics. In the current environment relative yield differentials are king, and after the Fed was perceived as dovish at the June meeting, the yield differential between Germany and the US continues to narrow, which is lending support to the single currency.

This supports our long-term view that EURUSD will not fall back to the multi-year lows from earlier this year of 1.05, and a return to parity is off the cards for now. The Federal Reserve also mentioned its sensitivity to dollar strength, which could limit upside in the buck over the summer months.

Takeaway:

• The EUR is remarkable stable in the face of D-day for Greece.
• The perceived dovish tone from the Fed is driving the FX and bond markets right now.
• Greek fears are having an impact on local assets and also weighing on stocks, however, there are no signs of contagion to other peripheral bond markets at this stage.
• We expect today’s Eurogroup meeting to end without a resolution for Athens, which would pave the way for bankruptcy at the end of this month.
• Although the announcement of a failed meeting could knock EURUSD in the short term, we continue to think that this pair will stay well above parity this year. 1.12 – the pre FOMC low  – and then 1.1050 are key support levels for EURUSD if we do see a sell-off before the end of this week.