Euro leaders open up to Greek default

illustration: euro

(13.07.2011) The debt unrest continues, and euro leaders do no longer exclude the possibility of one form of Greek default. Chinese Q2 GDP indicates that the landing in the second largest economy of the world will be soft.

By Kjersti Haugland, Senior Economist at DNB Markets

Risk remained off in yesterday's markets, and stock markets continued to fall. Italy remained in the eye of the storm, and the government is expected to deliver 40 bn euros worth of budget cuts in the course of the next days, in order to avoid a further loss of market confidence.

The current situation makes it clear how serious the contagion effect of uncertainty around the solution to the crisis-struck PIG-countries may become,
and forces the euro leaders to consider new solutions. The European finance ministers do no longer exclude the possibility of Greek default in order to ease the country's debt burden. One possibility may be that the EFSF fund buys Greek bonds in the secondary market, a solution advocated by representatives from European banks, but so far rejected by German authorities.

The European leaders will gather for an emergency meeting on Friday. Meanwhile, Moody's degraded Irish debt another notch yesterday, to Ba1, still with a negative outlook. The rating agency warned that further "emergency funding" may be necessary before the Irish will be able to obtain market funding again.
Nevertheless, the euro has strengthened slightly against the dollar since yesterday morning. The minutes from Fed's two-day-meeting in June showed that the members regard the outlook as unusually uncertain. Although still not up for discussion, QE3 is not excluded. "A few members" said that the committee may have to consider further monetary stimulus if the upturn remains weaker than necessary to lower the unemployment rate in the medium term.

The main principles for the exit strategy were agreed upon (against one vote) in the meeting. First step will be to stop reinvesting the principal of maturing assets, second step will be to change the forward guidance in monetary policy, the third step will be to start hiking the Fed Fund rate, and the forth step will be to start selling assets, starting with agency debt. These sales will start "sometime after" the first rate hike, and agency debt is expected to be removed from Fed's balance sheets in the course of a 3-5 year period.
Throughout the Asian session the Nikkei index has risen, which is mainly due to Chinese Q2 GDP, being slightly stronger than expected. The Chinese economy grew by 9.5% y/y in Q2, down from 9.7% in Q1, but stronger than consensus (9.4%). The world's second largest economy seems to go in for a soft landing, despite many tightening measures including interest rate hikes and increasing capital requirements for banks, directed towards curbing inflation and credit growth. According to the statistics agency, quarterly growth came up from 2.1% in Q1 to 2.2% in Q2. Note though, that the Chinese national accounts should be interpreted with great care, as they are released only three weeks after the end of the quarter (in Norway Q2 GDP will be ready in 2 months time!), and the numbers are barely revised.
UK inflation dropped surprisingly in June, to 4.2% y/y, down from 4.5% in May. Excluding energy, food and beverages, price growth declined from 3.4% to 2.7%. This may be the first sign that ample capacity is putting downward pressure on inflation, which has remained far above target for a long time. The combination of a feeble economic outlook and high and increasing inflation has been a headache for the monetary policy committee for some time. Food and energy prices will probably continue to lift headline CPI in the coming months, but if underlying inflation continues to fall, the arguments of the two hawks in the committee looses force.
Swedish core inflation (CPIF) declined from 1.7% y/y to 1.5% in June, 0.3 pp below consensus, and 0.2 pp below the Riksbank's estimate. The deviation is quite moderate, but serves to support our view that the Riksbank will skip one of their two expected hikes in the three remaining meetings of 2011. The market shrugged its shoulders, and the SEK has strengthened since yesterday morning.