The Reserve Bank board meets next week on July 5. It was clear from the tone of the minutes of the June board meeting and the governor’s speech last week that the board sees no immediate need to raise rates, despite holding a strong tightening bias. Therefore we see no reason to expect a hike on July 5.
In the governor’s speech, he clearly linked the next policy event to the June quarter inflation report which will print on July 27. We expect a print of the underlying measure of 0.7 per cent, not sufficient to justify a rate hike at the August meeting. We expect that a print of at least 0.9 per cent will be needed to justify a rate hike in August.
That will also be on the basis that there has been no major deterioration in global financial markets stemming from the European financial crisis.
For the last 10 days I have been travelling in the UK and Europe meeting real money managers, central banks and hedge funds.
Inevitably the discussion came to Europe.
I have to say that no one was optimistic for long-term stability.
It was generally agreed that the European way was to buy time in the hope that, in time, those troubled economies outside Greece would heal such that any eventual necessary restructuring in Greece would not be followed by immediate contagion.
Hence, everything that could be done to hold Greece together in global markets would be. Its total outstanding bonds are €340 billion of which 27 per cent are held by banks, and 43 per cent by real money managers, sovereign wealth funds and central banks. The ECB holds a further 16 per cent; the IMF the remaining 14 per cent. The German bank holdings are thought to be mainly limited to the German Landesbanks, which are not considered to be critical to the German economy. So, in the extreme, an orderly wind down of this sector is possible.
The possibility of the European community guaranteeing the entire volume of outstanding Greek bonds was supported by some arguing that a contagion would be far more expensive for Europe and the global financial system. However, the funding of future deficits – around €30 billion per year – would still be an issue.
The risk is not financial support from the EU, but social unrest in Greece. That could be partially averted by turning a blind eye to the government’s inevitable slow progress in implementing the reforms. The reforms are extreme, including fiscal tightening of 10 per cent of GDP over five years, would still see the debt-to-GDP ratio only stabilise to around 140 per cent of GDP by 2014, and would not stop an eventual default.
However, even if some broad-based but affordable mechanism can be agreed upon to keep Greece out of play for years, it is still questionable as to whether the other problem countries will make sufficient progress to make markets comfortable.
Of course, this approach would carry many risks. Would the social unrest in Greece ease, even if there is some genuine European leadership that can coordinate a soft touch? And if it becomes known to the Portuguese, Irish and Spanish that the EU is not insisting on tough policies, what incentive will the others have to comply? Thus, the risk of social unrest in Greece unwinding the rescue package, despite strong European intentions, looms large.
Elsewhere, economic progress appears to be getting underway slowly in Ireland, and at least they are not rioting in Portugal.
The EU could probably guarantee all of Portugal's debt and confidence might slowly return to Ireland, but what about Spain? Spain's debt, though only around 60 per cent of GDP, would be too large for a blanket EU guarantee.
Spain sits at the centre of the ‘buy time’ strategy. Spain has been subject to the bursting of a massive debt-driven property bubble, yet prices are not reported to have fallen by much. There is a clear anticipation that Spain will have to recapitalise its banking system, which will severely disturb its current benign debt position. The market is alert to distressed investors, who were very successful with distressed banks in Japan, finding it too hard and walking away in Spain.
There is already social unrest in Spain and, with the austerity measures, Spain is suffering from a housing meltdown along US lines. Whereas the US could afford to recapitalise and take the losses, Spain cannot – it is likely that default or hyper-inflation are the only solutions. The market will be watching Spain's attempts to grow out of these problems closely – albeit almost impossible to do so with trading partners that are also weak.
Stress tests are considered to be inadequate and a meltdown in Spain – which could affect Italy – is feared, despite any long-term band-aid jobs for Greece.
Other uncertainties complicate the outlook. One regulator worried about the identities of those banks with exposures to the sovereign CDS market and the magnitude of those positions, despite ISDA executives arguing that net exposures are limited to €5 billion.
European banks are major issuers of US dollar liabilities with a natural buyer being US money market funds. This link was one channel by which financial instability was propagated last time around. The Fed has just announced an extension of US dollar swap lines with European. The US MM funds may be unwinding their European bank exposures. With the exception of Germany, it is assessed that European banks have been slow to deleverage balance sheets.
Spain remains the key risk in this potential house of cards. A decision to neutralise Greece will buy time, but much more information will need to be revealed about Spain to achieve sustainable stability.
While social unrest in Greece, Portugal or Spain looms as an early circuit breaker, the market's acceptance that Spain will be able to deal with its problems seems optimistic. Debt-laden Italy also represents a risk, as does contagion to the US. A period of unacceptable volatility and uncertainty seems likely until it is accepted by the EU that the carving out of a new smaller homogeneous group of debtors is the only lasting solution.
In the short term, Europe, possibly including the demonstrators, is going on holidays, so prepare for an eerie couple of months.
Offshore fund managers argue that a 25bp rate cut priced in for Australia is a 25 per cent chance of a 100bp cut. In the current environment in Europe, you can see their point.