In recent months, various observers pointed to strains in the inter-bank funding markets. Headlines warning of financial calamity resurfaced. We have a laundry list of complaints ourselves. Remember, though, that Al Capone was convicted for tax evasion, not for his activity as a mobster. Credit Default Swaps (CDS) on Greece may be triggered not by Greece’s inability to pay, but because of Finland’s insistence that collateral be posted in return for the next tranche of European Financial Stability Facility (EFSF) payment. Along similar lines, select banks may have funding strains, but don’t count on a lack of liquidity breaking their backs.

Anyone who has read a basic accounting book recalls the equation Assets = Liabilities + Owner’s Equity. While specifics might get a bit complex (they shouldn’t, but when regulators and lobbyists collaborate, the result is not necessarily the most obvious), banks face the same accounting realities. A customer’s loan shows up as an asset on a bank’s balance sheet. Equity may be paid-in capital by shareholders. And liabilities are the loans the bank itself takes out in order to pay for (fund) its loan portfolio (assets). Unlike non-financial corporations, banks are highly leveraged institutions (low equity compared to liabilities); moreover, banks have an inherent maturity mismatch. A maturity mismatch means that banks tend to borrow short-term money, while financing long-term projects. Some of the key risks banks face are interest risk (the risk of rising short-term interest rates may create problems for institutions with a maturity mismatch) and credit risk (the risk of creditors not paying back their loans). By promising to keep interest rates low until at least the middle of 2013, the Federal Reserve (Fed) has substantially reduced interest risk for banks. The risk of creditors (think Greece’s sovereign debt; think sub-prime mortgage-backed securities, to name two of the more obvious risks), however, persists.

In order to finance their loan portfolios (a bank asset), banks have substantial funding risk. Funded can be sourced through customer deposits (a fairly stable source of funding; a customer deposit shows up as a liability on a bank’s balance sheet), by issuing various forms of debt (e.g. including longer term bonds or shorter term commercial paper) or by obtaining a loan from another financial institutions, the inter-bank lending market.

The obvious challenge in the interbank lending market is that if a bank does not trust another institution’s financial health, they are unlikely to give that institution a loan, even if it is just overnight. The financial institution seeking to secure financing may have its funding costs soar as a result. The important thing to remember, though, is that banks have access to funding from their respective central banks. The days are over when investment banks had neither customer deposits, nor access to a central bank window. Goldman Sachs, as well as the other remaining large investment banks, have converted to commercial banking charters. As such, they can tap into the same unlimited piggy bank as other banks. Importantly, the European Central Bank (ECB) has been providing unlimited liquidity to the European banking system. That’s unlimited, as in no limits. The banks are depositing part of their loan portfolio as collateral; in return, they receive cash. That cash may literally be printed out of thin air; central banks don’t need to find that money somewhere, they just need to enter a credit into the account that bank holds at the central bank.

It turns out the ECB model is rather flexible: when the crisis flares up, banks require more liquidity; when the crisis ebbs down, those facilities are wound down. The ECB has been adamant that their measures are temporary by design and independent of its broader monetary policy. While one can argue about the severity of the crisis or the quality of the collateral, it is correct that the ECB approach is more robust than that of the Federal Reserve (Fed). By buying trillions in mortgage-backed securities (MBS) and government bonds, the Fed has a bloated balance sheet that is cumbersome to manage. In contrast, the ECB has only printed a fraction of the money and could phase out its facilities within months (one year for the longest facility). The ECB is also providing unlimited U.S. dollar liquidity to European banks through swap arrangements with the Fed in cooperation with the Swiss National Bank (SNB) and Bank of England (BoE). Importantly, these facilities are designed to carry financial institutions through the New Year. Towards the end of the year, a lot of window dressing takes place, where financial institutions like to show “good” securities on their books. As a result, every year, there is concern that those issuing less desirable securities might get squeezed from the funding markets. While not without political risks in the U.S., it shows the determination of central banks to keep plenty of liquidity in the markets, and is a key reason why we believe a liquidity driven financial meltdown is off the table.

In the 1990s, the Bank of Japan showed that even a technically insolvent banking system could be kept afloat. Similarly, there may be solvency issues at some institutions, but central banks can keep them afloat.

When funding costs are too high, financial institutions have to de-leverage or raise more capital. The former can be expensive; indeed, banks have great leeway with regards to keeping securities at cost on their books, rather than adjusting them to market value. Part of the rational behind such regulation is that the maturity mismatch inherent to the banking industry means banks should be able to take a longer-term view. The markets have shown they have little sympathy for such twisted logic. The trouble is that, if indeed banks de-leveraged, they would have to recognize their losses, possibly wiping out substantial portions of their capital.

The latest round of European stress tests did something fabulous: the stress tests provided unprecedented transparency, listing the sovereign debt holdings of financial institutions. The market doesn’t need the regulator to tell them what’s good or bad; the market needs transparency. The market is now able to target what are deemed weaker institutions and “encourage” them to raise more capital or de-leverage. That ‘encouragement’ by the market is what has been driving both policy makers and bank executives. In many ways, it’s a wonderful dialogue. Policy makers and CEOs may be able to influence the timing of when governments and banks clean up their books / get their act together, but the action is firmly driven by the bond markets. However, there is one region where this “reform process” is sorely lacking with regards to sustainable fiscal policy: the U.S. It’s not a coincidence: the bond markets in the U.S. have not forced policy makers into action. Obviously it would be preferred to have policy makers and bank CEOs be ahead of the curve.

When it comes to financial institutions, the inherent design of bank regulation carries much of the blame. It’s not just the fact that banks are not required to mark down assets to market value; it’s also that national regulators typically consider their own government debt risk free. In the U.S., Treasures are risk free by regulation. Similarly, European banks ought to carry much of their capital in sovereigns, as those securities are acceptable to comply with capitalization rules; in contrast, corporate securities must be heavily discounted. In a world where some corporations may be less risky than their governments, those rules are outdated. Indeed, at times, there is a risk that inter-bank lending of corporate (financial institution) paper dries up, because regulation discourages taking on the counter-party risk of a bank and incentivizes more risky government securities instead. In Europe, where each Eurozone government regulates its own banking system, it’s urgently necessarily to centralize bank regulation, so that each member country’s bank is not ex-ante over-exposed to their own government paper. Naturally, the respective governments are opposed to such moves, as it may increase the cost of government funding if banks actually had to evaluate (and take seriously) the creditworthiness of their own governments.

What does it mean to investors?

• Banks that are under-capitalized may not lend as much, reducing economic activity. That may be a negative for equities. For currencies, however, it depends. In Japan, the yen has been benefiting from economic contraction: in the absence of a current account deficit, consumers save more as economic activity slows down. In the U.S., it the opposite: it easier to finance the current account deficit with economic growth, providing an incentive to policy makers to grow at just about any cost. Looked at it differently, the U.S. dollar may be much more sensitive to a misbehaving bond market; while it is behaving for now, the U.S. dollar may be under pressure should the market take a different view on long-term fiscal sustainability. Caught in the middle is the euro: with the current account roughly in balance, the euro can fare okay in an environment where banks restrict their lending and economic activity stalls.
• Volatility is likely to remain elevated as long as investors remain skittish regarding the amount of liquidity provided. However, keep in mind that central banks can act much faster than politicians. As liquidity concerns are addressed, the market will move towards focusing on solvency issues. The lines may be blurred at times because of above mentioned regulations and lack of transparency. It would be most helpful if policy makers decided to embrace transparency. Note, by the way, that there is nothing inherently bad about a bank de-leveraging; but by postponing the inevitable, stress is created in the system that benefits no one (except those shorting those banks, I suppose, which is then made banned by the regulatorsut I digress).

Because of the scale of the issues, policy makers have taken an ever more active role in the markets; we don’t see that trend abating. As a result, securities may increasingly be trading based on the next perceived move of policy makers, rather than on fundamentals. It’s a key reason why we focus on currencies, as, through the currency markets, investors can take positions on what we call the mania of policy makers. This Thursday, September 22, 2011, we are hosting a webinar discussing how investors may be able to manage the currency risk of their U.S. equity portfolio. According to our analysis, investors may be able to improve risk-adjusted equity returns by taking a pro-active approach to currency risk.

Axel Merk, Portfolio Manager, Merk Funds

• At the beginning of the year, we presented three debt crisis scenarios. In this document we look at the recent economic and political developments and present an update of our scenarios.
• Our main scenario is that the debt crisis will continue for a couple years and that we slowly will move towards a quasi-fiscal union. We expect the financial markets to continue scanning the systems for weaknesses and when it finds them rising yields are likely to force politicians to respond.
• Currently there are too many risk factors for things to calm down. The core countries are likely to take advantage of the high-risk environment to push through necessary reforms in the periphery countries. The response to the crisis is also likely to result in a continued gradual move towards more fiscal integration.
• The risk of a very negative scenario materialising, which would include a sovereign default and maybe even a euro area break-up, has increased but we still assess the risk to be low. The commitment among the euro leaders remains intact but the public opposition has risen.
• The main risk is a continued increase in public opposition. It is fuelled by the bailout bills in the core countries and further austerity measures in the periphery countries. The euro area has so far delivered decent growth despite the ongoing debt crisis. Looking ahead, we expect modest growth as the unwinding of imbalances in the public and private sector takes place. We expect growth of 1.7% this year and just 1.2% in 2012.

Watch list

• Fifth review of Greece by end- September.
• ECB buying through the Securities Market Programme (SMP).
• Ratification of EFSF enhancement in local parliaments by end- September.
• Recapitalisation of Spanish bank sector to be done before end- September.
• Spanish parliamentary election in November.
• French general election in spring 2012

Status on debt crisis scenarios

In January, we published Research Euroland: Debt crisis scenarios, 25 January 2011. The document contained three debt crisis scenarios. Nine months have passed and the debt crisis is even more intense now than it was then. We therefore find it appropriate to give an update on our view on the future of the euro area. The three possible scenarios outlined in January were as follows.

1. Crisis contained.
2. Euro bonds and quasi-fiscal union.
3. Default or euro break-up.

In January we said “We believe a scenario in which the crisis can be contained to be the most likely outcome of the European debt crisis but we should expect continued high market volatility for some time”. Currently the debt crisis is moving more in the direction of scenario two.

The crisis has clearly not been contained. Portugal has received an aid programme and the euro area leaders have endorsed a second bailout package for Greece (this package still needs to be ratified in member states). The debt crisis has spread to Spain and Italy where rising government bond yields have caused the ECB to reactivate the Securities Market Programme and purchase large amounts of mainly Italian government bonds. The fiscal boundaries as set out in the Stability and Growth Pact were never enforced and the irresponsible financial policy in many countries and reluctance to enforce harsh measures has sparked and fuelled the crisis.

No quantum leap has been taken with regard to fiscal integration but step by step we are moving towards closer co-ordination and more surveillance. Agreement has been reached to give the EFSF more flexibility and increase its actual lending capacity (awaiting approval by national parliaments). The Euro-Plus-Pact was endorsed in March and, among other things, obliges countries to incorporate the EU fiscal rules set out in the Stability and Growth Pact into national legislation. It has been agreed that the ESM will be an international financial institution based in Luxembourg with a EUR700bn capital base and that it can even intervene on an exceptional basis in the primary market subject to strict conditionality under a macroeconomic adjustment programme. In June it was agreed that the EFSF can also intervene in the secondary markets on the basis of an ECB analysis in order to avoid contagion. It was also agreed that the funds can be used to finance recapitalisation of financial institutions through loans to governments including in non-programme countries.

The six pack that should strengthen the Stability and Growth Pact has not yet been adopted because the European Parliament is asking for a reverse qualified majority voting but when agreement is reached on the final details the six-pact will also be a notable step towards closer co-ordination and more surveillance.

The move towards a quasi-fiscal union is a long and slow process – often delayed by national interests or the need to get consent from the European Parliament – but the direction is clear. Each time a crisis hits, the solution has been to come a little bit closer together. We expect this process to continue in the future.

New crisis scenarios

On the basis of recent political and financial market developments, we have updated and adjusted our debt crisis scenarios.

1. Debt crisis slowly calms down as austerity measures begin to work and a situation where Italy needs a rescue package is successfully avoided.
2. Turmoil continues and pushes a move towards a quasi-fiscal union and possibly at a later stage euro bonds.
3. Default or euro break-up.

It seems unlikely that the debt crisis will calm down any time soon. Removing the uncertainties surrounding the next rescue package for Greece should help but uncertainty remains about the possible need for a third Greek rescue package or help for Italy remains. Turmoil is thus likely to continue for quite a while and this would push the euro area even further in the direction of scenario 2, which has become our main scenario. Eventually we expect austerity measures to calm markets down but we do not expect this to happen until the more distant future. The risk that we end up in scenario 3 with some kind of euro break up has also increased due to a deterioration in the general support for further belt-tightening in periphery countries and in particular an increase in the resistance to further financial support in core countries. We still assess the risk to be low. The commitment among the euro leaders remains intact and the main risk is a continued rise in public opposition.

Case by case approach

Our main scenario is thus scenario two – that the debt crisis will continue while we move towards a quasi-fiscal union. We expect financial markets to continue scanning the systems for weaknesses and through pricing, force politicians to respond or as ECB President Jean-Claude Trichet recently stated, “When serious crises arise, such as the one that we have been in since 2007-08, they expose weaknesses as sure as x-rays show up the skeleton inside the body. A good way of not letting speculation take hold is to identify one’s own weaknesses upfront and to correct them. In the years that preceded the crisis, countries in particular had a false sense of security…Once again, the lesson that we Europeans must draw from this is to strengthen the governance and monitoring of economic and fiscal policies. That does not mean to say that the functioning of the financial markets does not need to be substantially improved. At the moment, the key word for all industrialised countries is confidence.”

Recently we saw an example of this in Italy, see Flash Comment: ECB expected to start buying Italy today, 8 August 2011. The Italian 10-year yield rose by more than 150bp in less than two months. Italy was forced to present a very ambitious plan. The first plan presented aimed at balancing the budget by 2014. This was not enough to calm the markets. The austerity measures were frontloaded aiming at a balanced budget in 2013. This was welcomed by the ECB, which responded by including Italian and Spanish government bonds in the SMP purchases pushing 10-year yields below 5%.

Also, France has been in the spotlight, which has forced the French government to present austerity measures that are expected to more than fulfil the targets set out in the French Stability Programme. This implies reducing the budget deficit from 7.0% of GDP in 2010 to 4.5% of GDP by 2012

In a crisis environment, the euro area leaders will continue to use a case-by-case approach in an attempt to prevent an escalation of the crisis. It is difficult if not impossible to predict where the next ‘blowout’ will be but we can highlight potential triggers and monitor developments very closely. There are simply too many risk factors and the member states’ economies are still not sufficiently strong to expect smooth sailing from here. The euro area leaders need to continue the process towards more economic integration and we expect Germany in particular to take advantage of the leverage from the financial markets to push through much needed reforms in the peripherals.

Putting more money in the EFSF would be a plausible next step towards further integration. A strict implementation of the six pact and the Euro-plus-Pact would also push the euro area in this direction.

Giving the European Court of Justice more powers to give verdicts in the case of violations of the Stability and Growth Pact as suggested by Angela Merkel in her speech on 7 September would be another possible move towards further integration. This would demand treaty changes, which Angela Merkel has also said should not be taboo.

Euro bonds – maybe in the distant future

Euro bonds is a possible end solution but we do not expect euro bonds to become reality until integration has been extended much further – if ever. Angela Merkel is against “collectivising risks”. In addition, the German constitutional court’s ruling on bailout packages, which also says that the German parliament is “forbidden from setting up permanent legal mechanisms resulting in the assumption of liabilities based on the voluntary decisions of other states” seems to be a no-go for euro bonds.

Euro bonds are attractive to indebted countries because they can secure cheap funding for all euro area countries. But it also means that market pressure on individual countries to deliver sound fiscal policies would disappear. When the debt crisis eventually calms down, this is an important mechanism to avoid future crisis. President Van Rompuy put it this way “It is the overall combination of institutional pressure, peer pressure and market pressure that will help to avoid getting into such difficulties again. All three have been enhanced…In the first decade of the euro, the markets were asleep. Now they are awake – and even if they are sometimes overreacting, they will not go back to sleep again. Market signals were not being transmitted in an early and more gradual way to states whose debt levels rose dangerously high or whose current account deficits were unsustainable.” So institutional pressure and peer pressure may have to take over successfully the role played by market pressure today before euro bonds would be a success. We believe getting there will require more turmoil, with high market volatility and a continued focus on the ongoing debt crisis.

Risk factors

The financial system is very vulnerable to negative surprises. Should one of these take place, it could set off a chain reaction with increased financial turmoil with rising tensions in money markets, a further increase in credit spreads and an additional fall in equity markets. Although it is difficult to pinpoint exactly what could trigger this, there are a number of candidates.

1. Renewed pressure on the Italian bond market, for example on negative budget news or political instability.
2. Greek vote on tough new austerity measures expected in early October
3. Uncertainty over the size of EFSF if it is necessary to buy continualsly in the secondary market to keep yields down in Spain and Italy.
4. Problems in finding agreement among EU leaders on further measures in the event of renewed tensions.
5. A negative event at a larger European bank.
6. Negative surprise on losses in the Spanish banking sector and problems with recapitalisation of this sector.
7. Increased focus on the burden sharing in Europe through EFSF could trigger downgrades of AAA countries, for example France (see Research France: No downgrade in 2011 – but small margin for error (24 August 2011).
8. France is coming under pressure, due to a sharp drop in houses prices, which would weigh on the French banking sector.

Inertia

The news coverage and market dynamics appear to play an important role in adding inertia to the debt crisis. The tendency for both media and market participants to focus mainly on the negative aspects is noteworthy. We have seen this recently in Italy and Greece where, for example, ambitious new austerity measures have attracted little attention.

Ireland stands out as a good example of how markets can begin to regain confidence. Since it received the bailout package, it has improved its public finances considerably and is now broadly following the bailout plan. This was also supported in the third IMF review. S&P has confirmed that Ireland’s rating is stable and has said that it does not expect Ireland to need a second rescue package. As a result, Irish yields have clearly drifted downward and the Irish 10-year yield is currently 8.5%, down from close to 14% in July.

We expect to see similar dynamics for other countries. We expect hard data to begin improving eventually and news flow to turn positive slowly – but it will take some time.

Growth outlook

Despite all these risk factors, we do not expect a recession as our main scenario. However, the risk of recession has been rising and we assess the probability to be around 20% currently. The euro area has previously delivered decent growth despite the debt crisis. Looking ahead, we expect very modest growth as the unwinding of imbalances in the public, private and financial sector takes place. In 2011 and 2012 we expect growth of 1.6% and 1.1%, respectively. This is a significant downward revision from the 2.2% in 2011 and 1.9% in 2012 published in our June global scenarios.

• Over the past month, equity markets have been declining, on the fear of recession and heightened uncertainty relating to European and US debt problems.
• In this document, we examine the pass-through from equity prices on the real economy. We conclude that a 10% fall in equity prices would lead to a fall in GDP growth of the order of 0.33pp annualised.
• The timing of the fall in equity prices might bias the estimate downward, as we are yet to see a take-off in the labour market and, with fiscal consolidation moving closer, the financial turmoil could not have come at a worse time.

Lower equities hurt both consumers and corporations

Since the end of July equity prices have been hit hard, as confidence in western leaders’ ability to tackle imminent debt issues has plummeted. The S&P500 shed 16% in a little over two weeks. In this paper, we examine how such a fall feeds into GDP growth and thereby whether the recent decline poses a long-term threat to the real economy.

Generally, equity prices feed into the real economy through a number of channels, with the major ones being consumer and corporate spending (see the chart overleaf for an overview of the dynamics).

Private consumption is particularly affected in the US, where households tend to be much more actively involved in equity markets than in Europe. A fall in equity prices would drive down both the size of equity holdings and household wealth. A mitigating factor to this effect is the reduction in interest rates as equities tumble. However, the overall effect on consumption is negative. Looking at an error correction model (see Appendix) for consumer spending, we estimate the long-term impact of a 10% fall in equity over a quarter would cut private consumption by 0.4pp on average. With consumption making up roughly 70% of GDP, this should reduce GDP by around 0.3% on the year. Though this might not seem very dramatic at first glance, it is worth noting that the recent decline in equity prices is likely to take some time to feed through completely. Hence, not only the magnitude but also the duration of the decline is important.

Corporate spending is influenced both directly and indirectly by equity prices. The direct channel comes through firms’ ability to refinance themselves in the stock markets. This is on average of the same order of magnitude as the effect of the S&P500 on consumer spending. However, there is also an indirect effect from changes in (expected) demand, that is a reduction in consumer spending feeds more than one-to-one into firms’ spending.

These two major channels are supplemented by the indirect effects of the above changes in domestic demand on both inventories and imports. This effect of domestic demand on imports tends to dampen the negative effects of a fall in equity prices.

Looking at the above effects combined, we expect a 10% fall in equity prices over a quarter to lower GDP by 0.08% q/q, equal to about 0.3% q/q annualised.

To get an idea of the dynamics, we have drawn up three scenarios based on the S&P500 index.

1. S&P500 recovers to 1350 by year-end and then rises by 10% in 2012.
2. S&P500 stays flat at 1230 until end-2012.
3. S&P500 declines to 1000 by year-end and stays flat in 2012.

In all three scenarios, the negative impact of equity prices remains throughout H2, due to the lagging nature of the wealth effect. The same goes for corporate spending, where equity prices are already dampening corporate spending. We do not expect this effect to go away until well into H1 12.

By summing the impact on consumer and corporate spending, along with the effect of imports and inventories, we end up with the total impact on GDP growth. It is evident that equity prices are less important now than in both the great recession and the downturn in the early 2000s, when GDP fell by more than 1pp y/y. The overall effect of equity on GDP is still expected to be positive for 2011 as a whole; however, the lagged effects are likely to drag down GDP well into 2012.

A major source of uncertainty regarding the above model is the impact of the timing of the shock. Even though the employment dynamics might be hurt only in the short run, we cannot preclude long-term damage from the current shock to the economy. With the takeoff in the labour market still waiting to be seen, the economy is much less resilient going into the austerity of 2012. This could mean a longer period of subdued job and consumption growth.

Key points

• Dollar negative factors to dominate over the next 12 months and push EUR/USD towards 1.50
• Still some value in the Scandi currencies as the market underestimate the risk of further monetary tightening
• USD/JPY to stay close to intervention levels as no support from US rates

The cyclical outlook has changed significantly over the summer and with it also the central bank outlook. The Fed now predicts near zero percent interest rates until at least mid-2013 and we expect it to be right in this prediction. Also, in the eurozone further hikes have been cancelled, as economic data has deteriorated and pressure on the European bond market has intensified – with a temporary drop in EUR/CHF towards parity as the most visible implication.

Notwithstanding weaker-than-expected growth, the medium-term outlook has turned increasingly dollar bearish, in our view. Zero rates for longer, a large current account deficit, lower domestic growth, high fiscal adjustment needs and increased political risks are not positive for a currency. We forecast the dollar depreciation trend will continue for longer than previously expected and that the dollar will not least depreciate against currencies backed by central banks where potential for further rate hikes remains, e.g. the Scandinavian currencies, the commodity currencies and the high growth emerging market currencies.

Event risks remain high, though, and policy responses are likely to remain an important market driver. If the European debt crisis has taught us anything, it is that markets will have to move very close to the edge for politicians to react. This means that the path towards a long-term solution is likely to continue to be characterised by recurring periods of market stress – and in turn recurring downwards corrections in EUR/USD. A significant worsening of the European debt crisis remains the most important risk to our forecasts.

Main forecast changes

The Fed’s prediction of zero rates until mid-2013 has increased the depreciation pressure on the dollar and we have opted to lower our dollar forecast significantly. We now forecast EUR/USD will reach 1.50 in 12 months – a significant revision to our old 1.36 forecast, which was based on the prediction of a first Fed rate hike during 2012. However, we have lowered our three-month forecast to 1.42, to reflect the expectation of continued weak macro data over the coming months.

Lower rates for longer in the US also imply that the long-expected depreciation of the yen, which was expected to go hand in hand with higher US rates, is likely to be postponed even further. We now forecast USD/JPY at 79 on a 12-month horizon.

Neither the SEK nor the NOK has been able to perform over the summer. This underlines that the Scandinavian currencies are not safe haven in the traditional sense. The weaker SEK and NOK have gone hand in hand with lower global risk appetite, a significant repricing of monetary policy expectations in both Norway and Sweden and the weaker cyclical outlook in both countries and globally.

However, in our view the repricing of monetary policy expectations in both countries has gone too far. In our main scenario, neither Norges Bank nor the Riksbank will cut rates over the next 12 months. On the contrary, we forecast that both central banks will restart their hiking campaigns if the dust settles in financial markets. Hence, in our view, risk is skewed to the upside for money market rates in both Norway and Sweden going forward and not to the downside as the market price today.

Even though the Scandinavian currencies are clearly not safe-haven currencies, we still believe that the market will tend to reward the currencies that will not be burdened by a counter-cyclical fiscal policy. However, this said, the experience over the summer underlines that even strong fundamentals are not enough for smaller business cycle sensitive currencies when risk aversion dominates and volatility spikes. To reflect the weaker cyclical outlook and lower risk appetite we have revised our EUR/SEK forecast slightly higher and now expect the cross to fall to 8.90 on a six-month horizon. We expect EUR/NOK to fall towards 7.70 in the same period.

The CHF90bn liquidity increase by the SNB and market expectations of further policy measures (e.g. a temporary EUR-CHF peg) have weighed on the Swiss franc. Hence, the EUR/CHF outlook will largely depend on what further policy measures are taken. We expect either a temporary peg or SNB intervention, which should stabilise the franc but not weaken it significantly. Risks are still to the downside in EUR/CHF. We forecast EUR/CHF at 1.15 at the entire forecast horizon.

Global recovery or recession?

The cyclical outlook has deteriorated rapidly over the summer to the point where economic indicators suggest a non-negligible risk of recession. This is a big blow to the consensus analysis, which, until recently, assumed a reacceleration in global growth during H2 11 as the three negative shocks from earlier this year faded (higher oil prices, Japan earthquake and Asian monetary tightening). However, leading indicators have not recovered but have instead continued declining – in sharp contrast to the forecast rebound in economic activity.

Our economists still expect a recovery in activity data later this year and forecast that the global and US economy will avoid a recession. However, this is not the same as saying that the market will not price a risk of recession. With leading indicators expected to decline further (Danske Bank forecast the ISM at index 45), recession fears are likely to stay elevated and potentially even rise further.

Market expectations have already been scaled back

While economic data is expected to deteriorate further, it is important to note that growth expectations have already been scaled back significantly. Back in February, the consensus expectation for 2011 US growth was 3.2% (as surveyed by Bloomberg). This has now been reduced to just 1.8%, as shown in Chart 2. This means that it will be much more difficult for the market to continue being disappointed going forward. In other words, the greater part of adjustments in market expectations is likely to be behind us – and, hence, perhaps also the greater part of the price adjustment in risk assets.

As Chart 2 shows, economic data has in fact delivered fewer disappointments lately, with the US economic data surprise index slowly moving higher again. This is a pattern often seen on the market; first economic data begins to deteriorate, triggering an adjustment in market expectations and a correction in market prices, but then, as expectations are eventually adjusted to the new growth outlook, economic data stops disappointing, which in itself is a positive shock to market sentiment and potentially even enough to trigger a rebound in market prices. Table 1 shows that during the past two growth scares in 2008 and 2010 the economic surprise index bottomed out more or less simultaneously with the equity market.

With indications of a trough in the US economic surprise index and with market growth expectations having been reduced significantly, we could perhaps already be near a bottom in risk assets. In this respect, it is interesting to note the tentative signs of a peak in FX option market volatility, which previously led a recovery in market sentiment (see Table 1). This is not to say that we feel confident in calling a recovery in risk sentiment but rather that it is likely to require new negative shocks to the market to trigger another 13% drop in stock prices, as the negative phase of reduced growth expectations has already come far.

Dollar implications – medium-term outlook turns more bearish…

Going into 2011 there were plenty of reasons to sell the dollar. Now, as we approach 2012, this list has become even longer.

• Large current account and BBoP deficit.
• Zero interest rates for longer – the Fed predicts until at least mid-2013.
• Weak cyclical outlook – below trend growth and high unemployment.
• Large fiscal adjustment needs and risks – another US credit downgrade is likely.
• Potential for accelerated reserve diversification out of the dollar.
• High political risks – as illustrated by the recent debt ceiling negotiations.

In fact, the only medium-term dollar positive factor currently is valuation, with the dollar trading around 14% undervalued according to simple REER (PPP) analysis. With most structural factors pointing towards dollar weakness we expect the dollar to re-embark on a medium-term depreciation trend and, hence, to become even more undervalued. More specifically, we expect the DXY dollar index to depreciate by more than 2% in 12M and for the dollar to remain the world’s favoured funding currency.

The currencies most likely to gain against the dollar are those: (i) backed by economies with little fiscal adjustment need and (ii) backed by central banks where the money market can price expected hikes again, when global macro data recovers. These include the AUD (almost 140bp cuts priced in 12M), the NZD (only 50bp hikes priced in 12M), the CAD (one 25bp cut fully priced), the NOK (one 25bp cut fully priced) and the SEK (close to two 25bp cuts fully priced). We forecast all of these currencies will appreciate by at least 4% against the dollar in 12M and for AUD/USD to reach 1.10 again.

Given the current market conditions, only two scenarios could reverse the medium-term dollar depreciation trend in our view: (i) a recession or (ii) a more severe European debt crisis. This is similar to the situation of the past 10 years, where also only a recession (the 2008 financial crisis) was able to cause more than a short-lived reversal of the underlying dollar downtrend – see Chart 3.

…but short term dollar support could still materialise

Structural dollar weakness does not rule out temporary dollar support, however. As we have argued, deteriorating macro data could cause recession fears to rise even further. In this scenario, we would expect safe-haven and deleveraging flows temporarily to take the dollar higher, especially if a further decline in global PMIs coincides with increased pressure on European bond markets.

How high a probability should we attach to this scenario? This is a difficult question, as the market is currently very sentiment driven. However, it is certainly a risk scenario that needs to be considered. Not least because market positioning still leaves potential for dollar strength. According to the latest IMM report, non-commercial investors (a good proxy for overall speculative positioning) have unwound only half of their aggregate short dollar positions, which still leaves net short positions at USD15bn.

We have factored in the potential for higher recession fears to our forecasts, by leaving the bigger dollar depreciation on the 6-12M horizon. We have factored in the potential for higher recession fears to our forecasts, by leaving the bigger dollar depreciation on the 6-12M horizon. In 3M we forecast EUR/USD at 1.42, GBP/USD at 1.60, USD/CAD at 1.00 and AUD/USD at 1.03.

EUR/USD to move higher during 2012

The dominating driver on the currency market this year has been relative monetary policy. This is not least visible in EUR/USD where a wider interest rate spread has taken the spot from 1.30 to 1.40. However, with the ECB now likely to be on hold, relative monetary policy will become less of a euro supportive factor. In the short term relative rates are clearly a downside risk to EUR/USD (see Chart 4) – as a potential ECB cut cannot fully be ruled out.

While we do not expect either the Fed or the ECB to change the policy rate during the next 12 months, we still see potential for European money market rates to rise more than US money market rates. With the US money market curve more or less tied to the zero rate floor for the coming year, most of the volatility in relative rates should be expected to come from European rates.

Event risks remain plenty

If the European debt crisis has taught us anything, it is that markets will have to move very close to the edge for politicians to react. This is perhaps not that surprising, as politicians do not want to introduce too much ‘moral hazard’ to the system and as politicians have to cater to their domestic voter base in order to stay in the job. However, this also means that the path towards a long-term solution to the European debt crisis is likely to continue to be characterised by recurring periods of market stress. This in turn means recurring periods of rising market volatility and probably also downward corrections in EUR/USD – and depending on the SNB policy response, also in EUR/CHF. A significant worsening of the European debt crisis remains the most important risk to our forecasts.

Event risks are also present for the dollar, however. We see a high probability of yet another US credit downgrade, see Research: Further downgrade of US debt likely in 2012. To what degree this, and the higher political risks in the US, will accelerate reserve diversification out of the dollar remains to be seen.

• The recent years’ fast rise in US gross debt combined with a deterioration of economic outlook has resulted in concern about future fiscal sustainability. In response Standard&Poor’s (S&P) have downgraded US sovereign debt to AA+ and Moody’s and Fitch have put US on negative outlook.
• The President’s current budget proposal involves a reduction in the budget deficit throughout the next decade. Nevertheless the deficit will persist, which contributes to further increases in US debt, and in ten years time the US gross debt ratio will reach 116% of GDP under the current budget.
• Because of the complex interrelationships between the budget and the economy, the budget estimates depend to a very significant extent upon assumptions about the economy. Hence changes in economic circumstances can worsen the situation about the US sovereign debt. In the paper we look at different scenarios for growth, interest rates and budget changes to see how sensitive the debt outlook is to these factors.
• Our analysis shows that a more severe downturn in economic growth as well as a drop in investor confidence resulting in higher interest rates could lead to a significant increase in the debt to GDP ratio.
• An economic downturn implies a dual pressure on politicians and in case the politicians succumb to the pressure from lower growth and abandon fiscal discipline it will have considerable effects on debt.
• Based on the increasing economic uncertainty we believe Moody’s and Fitch will follow the footsteps of S&P and downgrade US debt from its’ AAA rating. Moreover, a further downgrade from S&P to AA is likely in 2012. This will add to financial uncertainty in 2012.

Is fiscal sustainability under threat?

The financial crisis triggered a rising path for the US gross debt as it increased from around 60% in 2007 to around 100% in 2011. Despite the rapid pace of the rising debt, the current level is relatively modest compared with other major OECD countries. However, the future path for the debt seems a bit more concerning, and based on the recent fiscal consolidation plan S&P have downgraded the US sovereign credit rating to AA+, as they do not find the plan ambitious enough.

In addition, economic growth seems to be weaker than expected in 2011 and 2012. This puts additional pressure on fiscal sustainability, due to the negative economic conditions significantly affecting the budget, which again affects debt negatively. Moreover, there is a risk that the economic concern will spill over to investor confidence and result in higher funding rates. This risk seems smaller at the moment, though, as Fed will try to compensate by keeping rates low for longer. All of these uncertainties about the economic situation place a twofold pressure on the politicians. On one side they wish to stimulate economic growth but on the other hand they need to secure fiscal sustainability and preserve fiscal restraint. And the worse economic growth turns out the more spending cuts they need to put forward to get the deficit down as planned.

Interaction between economic conditions and deficit

In order to examine the implications of possible changes in economic assumptions we use the sensitivity estimates provided by The Office of Management and Budget (OMB). Based on a fixed budget policy, they provide a set of rules of thumb which we use to assess the impact on the budget of different GDP growth paths and interest rate scenarios. As the rules of thumb are based on a fixed budget policy, the fiscal policy will stay the same even though economic conditions change.

As economic variables which affect the budget usually do not change independently of one another, it is assumed that the unemployment rate will be 0.5 percentage point higher for each one percent shortfall in the level of real GDP, compared with the baseline. This assumption implies a reduction in taxable income growth and hence an increase in debt. Other economic variables are held constant.

Main scenario: Lower GDP growth

The Congressional Budget Office (CBO) projects the economic situation in the US based on the current budget proposal (The president’s Budget) and estimates an increase in GDP growth rate from 3.6 % in 2011 to 5.5% in 2015 after which it slowly declines to a rate of 4.3% in 2021.

Based on the recent disappointing growth prospects these assumptions look quite optimistic and our main scenario is that the growth rate will be lower than estimated under the 2012 Budget. We consider two cases of lower growth in GDP each associated with a corresponding rise in the unemployment rate.

• GDP growth is 2pp lower compared with CBO’s estimates from 2011 to 2015 followed by a gradually return to the baseline GDP growth rate in 2018.
• A GDP growth rate of 1.5% until 2015 also followed by a return to the baseline GDP growth rate over the ensuing three years.

The first case is seen as a bad but likely scenario, whereas the second setup primarily is used to measure the sensitivity of the debt and does not reflect our expectations.

Under both scenarios the primary budget stays at a lower level during the normalization compared with the projection under the President’s Budget. This is a consequence of lower receipts due to a lower growth rate and higher outlays due to a higher unemployment rate. Further, the interest payments on debt increases in these cases, and both of these effects contribute to a higher debt ratio compared to the baseline scenario.

Consequently, the scenarios with 2pp lower GDP growth rate and 1.5% growth rate result in a debt projection, where gross debt in percent of GDP is at 132% and 143% in 2021, respectively. Compared with CBO’s estimate of the gross debt ratio of 116% in 2021, the debt ratio is significantly affected by the lower economic growth rates.

Even in the likely case, where economic growth is 2pp lower during 2011-2015, there is a 38pp increase in the gross debt ratio from 2010 to 2021, and definitely not a stabilization at the current level.

Risk scenario 1: Fiscal discipline not kept

The analysis regarding lower GDP growth is made under the assumption that the government does not implement new fiscal stimulus measures to counter the lower growth rates, as the rules of thumb are based on a fixed budget policy. However, this is not necessarily a realistic assumption since unexpected downturns in economic growth, and attendant job losses, usually give rise to legislative actions to expand unemployment benefits, stimulate the economy with additional Federal investment spending and the like. This implies that the 2012 Budget, which provides a path to lower medium-term deficits, could be overruled by stimulating fiscal policies in case of a downturn.

Under the president’ Budget CBO estimates that the primary budget deficit will be at 9% of GDP in 2011 declining to 2.6% in 2015 followed by a nearly constant level the ensuing five years. In order to estimate the debt ratio’s sensitivity of a deviation from the 2012 Budget we consider two cases.

• The primary budget is 3pp lower from 2012 and onwards compared with CBO’s estimates, hence there is a reduction in the primary budget deficit, but the politicians are not able to reduce it as much as estimated in the baseline scenario.
• The government continues with a primary budget deficit at the same share of GDP as in 2011. This is seen as a pessimistic and less likely scenario but made to illustrate what will happen if politicians do not reduce the budget deficit soon.

The effect of a higher primary budget deficit in percent of GDP affects the debt ratio directly, but it also affect it through an increasing interest payments in percent of GDP. Consequently, the gross debt ratio continues increasing after 2011 and will reach a ratio of 175% of GDP in the scenario, where the primary budget is kept at the 2011 level. The outcome is a bit more moderate under the 3pp lower primary budget, where the debt ratio reaches 144% of GDP in 2021.

Compared with the CBO projection of a debt ratio of 116%, there are major consequences for gross debt when the fiscal discipline weakens. However, there could be a positive second round effect of higher growth as a result of the economic stimulation. This is not taken into account here.

Risk scenario 2: Drop in investor confidence trigger higher bond yields

In our analysis US debt default unlikely, downgrade likely it appears that a downgrade would imply a moderate positive reaction in Treasury yields, as there was already a 50/50 probability of a one-notch downgrade priced in. Nevertheless, there is a future risk of a turn in investor confidence, which could send treasury yields and thereby funding costs markedly higher. Although probably less likely than the low growth scenarios it cannot be ruled out if confidence slips significantly as seen in for example several European countries. To some extent Federal Reserve will counter this by keeping rates low – and possibly buying more treasuries. But some increase in bond yields could still take place and worsen the debt dynamics.

CBO assumes that funding rates will increase rapidly over the next 10 years starting from a level of 1.9% in 2011 reaching 3.8% in 2021. However, a drop in investor confidence could result in further increases. We consider two different scenarios,

• Interest rates increase 1pp above CBO’s estimate each year, which could be a consequence of further downgrades of the US sovereign debt or a drop in investor confidence.
• Interest rates increase with 3pp each year. This is seen as a less likely situation, which is mainly used to analyze the sensitivity of US debt to a drop in investor confidence.

To estimate the effect of bond yield increases, it is taken into account, that only part of the debt will mature each year, such that the higher interest rates affect the economy gradually.

The two interest rate scenarios result in a debt ratio of 124% and 141% of GDP in 2021, respectively. The higher debt ratio is mainly a consequence of a major increase in interest payments due to higher interest rates. Concerning the primary budget, the outlays are kept almost constant. However, there is a minor increase in revenues from the government account’s security holdings as well as an increase in individuals’ income and financial corporations’ profits, which gives the government a higher tax income, thus affecting the primary budget and hence the debt ratio positively.

Interaction between the scenarios

The three scenarios above highlights that there are a lot of uncertainties concerning the future path of the US debt. However, it is insufficient to consider each case separately. This follows because lower economic growth will increase the need for fiscal stimulation, hence it can result in the absence of fiscal restraint. A weakening in fiscal discipline puts further pressure on the future fiscal sustainability, which at some point in time could affect investor confidence negatively resulting in higher interest rates. As a consequence of higher funding rates economic growth will decrease and the economy has entered a negative spiral with increasing debt.

To analyze a situation, where the independency between the three scenarios is taken into account, the three most likely cases above are combined. This implies a scenario which involves,

• Compared with CBO’s estimates the GDP growth is 2pp lower from 2011 to 2015 followed by a recovery to the base-case level over the ensuing three years combined with a resulting drop in employment rate.
• The interest rates are 1pp higher than the assumption made by CBO, again taking account of the average maturity on the debt.
• The primary budget is 3pp lower compared to CBO’s estimates from 2012 and onwards before taken account of the secondary effects from GDP growth and interest rates.

The composition of the three cases entails a higher deficit on the primary budget as it is assumed to be higher but also as a consequence of the lower growth rate in GDP and hence the higher unemployment rate. Further, the interest payments will be much higher compared with the baseline case under CBO, as the debt ratio is kept high, but also as a consequence of the drop in investor confidence. As a result of these aggregate effects, the debt ratio ends on 171% of GDP in 2021. Compared with CBO’s baseline case, where the debt ratio is 116% of GDP, this is a really bad outcome.

Although the economy can end in this negative spiral, it is not certain that investors will lose confidence solely as a result of a weakening in fiscal discipline. Further there is a probability, that the fiscal stimulus can create economic growth, and probably stop the spiral. But it requires an increase in the primary budget deficit and hence a rise in debt ratio. The scenario serves to illustrate the snowball effect if the debt problems are not dealt with in time.

Moody’s likely to remove AAA rating and S&P downgrade further to AA

Our analysis show that a downturn in economic growth, higher interest rates or a deviation from fiscal restraint will all affect the US debt sustainability negatively. Especially the scenario with lower growth seems likely. For that reason, S&P, Moody’s and Fitch have kept their outlook on negative, meaning that there is a high likelihood that the rating could be lowered. With a weaker growth profile than currently anticipated we find it likely that a higher debt trajectory will trigger a downgrade to AA+ by Moody’s and Fitch and to AA by S&P during 2012.

A reduction in the rating by Moody’s and Fitch will again add to financial uncertainty, and the impact from a downgrade by one of these rating agencies will be more comprehensive compared to S&P’s first downgrade. This follows because many funds are only forced to sell AAA paper if more than one rating agency removes the AAA rating. Moody’s has indicated that there would be a risk of downgrade if (1) there is a weakening in fiscal discipline in the coming year; (2) further fiscal consolidation measures are not adopted in 2013; (3) the economic outlook deteriorates significantly; or (4) there is an appreciable rise in the US government’s funding costs over and above what is currently expected.

We expect economic growth to be lower than predicted by CBO, which implies that unemployment will stay at a high level and this will lead to a higher debt profile than currently projected by CBO. The view on longer term growth prospects may also be downgraded as consensus may build that US is caught in a low growth trap – similar to what Germany experienced following their housing bubble with relation to the reunification in the early 1990’s. As a consequence it is likely, that Moody’s and Fitch also downgrade the US debt.

In addition S&P have stated that the rating could be lowered further to AA within the next two years “if US cuts spending less than agreed to or other factors result in a higher trajectory for government debt”. S&P have previously shown their willingness to downgrade more than once within a short period, as they downgraded Japan three times during a period of fourteen months in the beginning of the twenty-first century.2 With the outlook for longer term growth looking disappointing we expect another downgrade by S&P during 2012.

A counterargument against a further downgrade from S&P or a remove of the AAA rating from Moody’s and Fitch is political pressure. As 2012 is election year both political opposites put pressure on the rating agencies not to downgrade. However, S&P’s recent downgrade illustrates, that they do not succumb to political pressure, and we expect a disappointing growth trajectory to be sufficient to trigger further downgrades.

Executive Summary

In the first of two special reports on the European sovereign debt crisis, we analyze the second bailout package for Greece that leaders of the European Union (EU) recently announced. Our calculations show that the package should stabilize the government’s debt-to-GDP ratio at approximately 160 percent over the next few years. However, the calculations are sensitive to assumptions about nominal GDP growth and the government’s primary budget surplus. If the Greek economy should stagnate at fairly slow rates of nominal GDP growth or if the government is unable to incur large primary surpluses for an extended period of time, the debt-to-GDP ratio will rise further. In our view, it would be premature to state that Greece is “out of the woods.” In a soon-to-be-released second report, we will analyze debt sustainability in some other highly indebted European countries.

Greece Receives Its Second Bailout Package in Two Years

Leaders of the EU recently agreed to extend a second bailout package to Greece. Between the EU and the International Monetary Fund (IMF), official institutions will loan the Hellenic Republic an additional €109 billion to help it meet its financing needs over the next few years. Greece received its first bailout package, which was worth €110 billion, from the EU and the IMF in May 2010 under the assumption that it would be able to return to private capital markets by 2013. However, it became painfully obvious over the past few months that the private sector would remain closed to Greece for the foreseeable future, which precipitated the need for a second package.

Greece’s main problem is the amount of its outstanding debt. To help alleviate its crushing debt burden, the EU will reduce the interest rate that the Hellenic Republic pays on its bailout funds from about 5 percent at present to 3.5 percent, at least initially. In addition, the EU will push out the repayment period from the current 7 years to a minimum of 15 years. As a condition for the second package, some European governments demanded that the private sector provide debt relief to Greece as well. Thus, the private sector has also offered to create voluntary debt exchanges that the Institute of International Finance (IIF), which spearheaded the private-sector participation effort, estimates will provide €54 billion of relief by mid-2014 and €135 billion by the end of 2020. The IIF estimates are based on an assumption of 90 percent participation.

Some of the exchanges allow investors to swap their current holdings of Greek government securities for new bonds that the Hellenic Republic will issue. Investors also have the option of holding current Greek bonds until maturity and then rolling into new bonds. Although the new bonds that Greece will issue will pay lower coupons than current securities, which helps to provide debt relief, the new Greek bonds will be collateralized by zero coupon AAA-rated bonds that give investors some recourse in the event that the Greek government fails to make payment.

A buyback facility for Greek government debt will also be established. Presumably, the Greek government will receive funding from the European Financial Stability Facility (EFSF), which is the €440 billion war chest that was set up by the EU last year to help highly indebted European countries. The Greek government would then buy back its debt in the secondary market, which will help it reduce its outstanding private-sector debt. The exact size of this buyback facility has not yet been announced.

Is Greece Out of the Woods?

As we described in a previous report, there are four variables that determine a country’s government debt-to-GDP ratio.1 First, the ratio tomorrow depends on its value today. Second, the ratio will tend to rise over time if the government incurs a primary fiscal deficit, which is defined as a situation in which government spending (net of interest payments on past debt) exceeds government revenue. That is, debt will tend to rise if the government spends beyond its means. However, the government may still be able to incur a primary deficit without provoking an unsustainable situation as long as nominal GDP growth, which is the denominator in the debt-to- GDP ratio, exceeds the rate of interest the government needs to pay on its debt. Therefore, interest paid on the debt and the nominal growth rate of the economy are the third and fourth factors determining sustainability, respectively.

Economists generally define debt sustainability as a situation in which a country’s debt-to-GDP ratio is stable. As the figures below show, Greece’s debt-to-GDP ratio was essentially stable around 100 percent between the mid-1990s until 2008. The deep recession caused Greece’s fiscal deficit to widen dramatically, which led to the jump in the debt-to-GDP ratio. In 2010, the ratio exceeded 140 percent.

To determine if the new EU plan will stabilize Greece’s debt-to-GDP ratio, we developed a basecase scenario with two primary assumptions. First, we assumed that nominal GDP in Greece will grow in accordance with the IMF forecast between 2011 and 2015. From 2016 until 2030, which is the end of our projection period, we assumed that nominal GDP would grow 3.5 percent per annum.2 From 1999 to 2007, nominal GDP in the “core” Eurozone countries grew at an average annual rate of approximately 3.5 percent.3 During the same period, Greece averaged a nominal GDP growth rate of 7.5 percent per annum, but we expect that this exceptionally high rate of growth will be difficult for Greece to achieve, at least for the foreseeable future. Therefore, we use 3.5 percent, the average growth rate in the “core” Eurozone during “normal” times, as our longrun growth rate for Greece.

Second, we assumed that the Greek government would incur an annual primary surplus of 3.0 percent of GDP over the projection period, which is the primary surplus that is implied in the EU stabilization program. As discussed below, we perform some sensitivity analysis around the primary budget surplus. Achieving a 3.0 percent of GDP budget surplus in Greece is not impossible, but it will be challenging because it would require a 5 percentage point swing from the current rate. Greece recorded primary budget surpluses equivalent to 3 percent of GDP in the late 1990s, but it has subsequently been in chronic deficit. Since 1993, 30 OECD countries have achieved 3 percent of GDP primary surpluses only 20 percent of the time.

We also needed an interest rate assumption. When investors exchange their current holdings of Greek debt for new securities there are three different coupon rates that depend on the type of exchange that is made. We used a weighted average of these rates as the interest rate in our projections. Under these assumptions, we found that the recently announced bailout package will stabilize the Greek debt-to-GDP ratio at approximately 160 percent (Figure 1). Although the debt-to-GDP ratio stabilizes, it does so at a ratio that historically has not been conducive to robust economic growth.

Next, we decided to change the growth rate to check the stabilization program’s sensitivity to different rates of nominal GDP growth. (We kept our primary surplus and interest rate assumptions unchanged.) Under our optimistic scenario, Greece returns to its prerecession growth rates near 7.5 percent after 2015. Under this assumption, Greece’s debt-to-GDP ratio will stabilize in the near term and then begin to decline after 2015 as strong nominal GDP growth kicks in. We also calculated a pessimistic scenario in which the Greek economy stagnates over the next 20 years with a nominal GDP growth rate of just 1.5 percent per annum. Under this scenario, the country’s debt-to-GDP ratio continues to rise indefinitely. This analysis shows the importance of strong economic growth. In that regard, it will be important for Greece to enact structural reforms that are aimed at raising the country’s long-run economic growth rate. If the Hellenic Republic does not follow through on these reforms, it will be more difficult to stabilize the debtto- GDP ratio, everything else equal.

Although the country’s growth rate is only indirectly under the control of the government, it has more power to determine the primary surplus. Therefore, we conducted some sensitivity analysis in which we maintained nominal GDP growth at 3.5 percent in the long run but varied the primary surplus. Under the optimistic scenario in which the Greek government incurs a primary surplus of 5.0 percent of GDP for the next 20 years, the debt-to-GDP ratio will gradually decline (Figure 2). This scenario is incredibly optimistic, however. Running primary surpluses of more than 5 percent of GDP on a sustained basis is very rare.5 Sooner or later voters grow weary of austerity. Under the assumption that the Greek government falls short and incurs primary surpluses of only 1 percent of GDP per annum, then the debt-to-GDP ratio will continue its upward trajectory.

Conclusion

Greek debt markets have reacted favorably since the second bailout package was announced last week. The yield on the 10-year government bond has dropped about 300 bps since the announcement, and the yield on the 2-year note has come down more than 1000 bps over that period. However, at yields of 28 percent for the 2-year note and 15 percent for the 10-year bond at present, investors do not seem to be convinced yet that Greece is “out of the woods.”

Indeed, our analysis suggests that it would not be credible to consider the Greek debt crisis “solved” just yet. Under our base-case scenario of 3.5 percent long-run nominal GDP growth and a 3 percent of GDP primary surplus, the debt-to-GDP ratio of the Greek government will stabilize around 160 percent of GDP. However, a debt-to-GDP ratio of 160 percent of GDP is hardly stellar. Among 30 OECD countries, only Japan would have a higher ratio. Moreover, what happens if there is another negative shock? If nominal GDP in the Hellenic Republic grows slower than 3.5 percent per annum in the long run, the debt-to-GDP ratio will rise further. Incurring primary surpluses of 3 percent of GDP indefinitely is not impossible, but it will be very challenging. In a best-case scenario, the debt-to-GDP ratio of the Greek government will recede over time. If these favorable conditions do not materialize, however, the Greek debt problem will raise its ugly head again.

Greece is not the only European country with questionable debt dynamics. In a soon-to-bereleased follow-up report, we will analyze debt dynamics in Ireland, Portugal, Spain, Italy and Belgium.

U.S. Monetary Policy

In the last Saxo Bank Quarterly Outlook, for Q2 2011, we came to the conclusion that U.S. Monetary Policy rates would remain on hold at least until the end of 2011 and very possibly until 2013. At the time, this was by no means the consensus view; the economy seemed to be in the midst of a moderately strong recovery, unemployment had declined for several months in a row, falling to 8.8 percent in March, down from 9.8 percent in November 2010, and even core inflation had struggled up to 1.1 percent from its low of 0.6 percent in the previous October.

We were concerned about events in the Middle East and North Africa, (MENA), the Eurozone debt crisis, and the terrible Japanese earthquake and tsunami; we felt all three had the potential to at least dent economic confidence and, in the case of the latter, the capacity to have a real physical impact on U.S. production.

As it is, all three have indeed lead to what must be described at the time of writing as (at the very least) a ’soft patch’- both in the U.S. and globally. Continued tensions across MENA, and the military intervention in Libya, have no doubt contributed to elevated oil prices and, in turn, the high price of gasoline has hit U.S. consumer confidence, which fell to 60.8 in May from 72.0 in February, according to the Conference Board’s index.

The Eurozone debt crisis rumbles on, with political expediency dominating the stances of both debtor and creditor countries. The former face revolts against austerity measures, both at the polls and in the streets, and the latter faces revolts against the extension of yet more largesse to the periphery, as exemplified by election results in Finland and Germany. Increasingly, the mood seems to be shifting towards an attempt to cajole private investors to share some of the burden, maybe via the euphemistically named ‘reprofiling’ of Greek debt – ‘pretend and extend’ to you and I. Finally, the supply chain interruption from the Japanese disaster has perhaps had the biggest tangible impact on the U.S. economy; vehicle production has borne the brunt, falling by approximately 10 percent this quarter so far, probably reducing GDP by about 0.5 percent in Q2. So, where are we now? The hawks on the Federal Open Market Committee are suddenly very quiet and the doves including, most importantly, the ruling troika-Bernanke, Yellen and Dudley, appear vindicated and firmly in control.

As recently as 7 June, in his speech at the International Monetary Conference, Chairman Bernanke was at pains to bemoan the “frustratingly slow” pace of recovery, observing that easy monetary policies “are still needed” given the economy continues to perform “well below its potential.” He made it crystal clear that he viewed headline inflation to be temporarily elevated due to factors beyond his control, such as the price of oil, ‘rather than factors specific to the US economy’, and obviously felt that the huge amount of slack in the labour market would serve to rule out ’second round’ increases in inflationary pressures as far as the eye can see.

With respect to the other part of the Fed’s dual mandate, employment, he had this to say- “although it is moving in the right direction, the economy is still producing at levels well below its potential; consequently, accommodative monetary policies are still needed. Until we see a sustained period of stronger job creation, we cannot consider the recovery to be truly established.” He also made reference to the probability of an impending fiscal drag, (even cautioning against tightening that was too rapid), as it now seems politicians are intent on showing they ‘get it’ and want to ease the electorate’s fears over exploding government debt, (albeit the parties remain poles apart over the means of implementation of this new-found probity).

So there we have it, straight from the horse’s mouth.The futures markets have now come round to our belief that rates will be on hold well into H2 2012 and, we feel, probably 2013. On the subject of quantitative easing, Bernanke was careful to describe monetary policy as ‘no panacea’, which observers have come to read as a warning that the hurdle to QE3 remains high, depending as it does on the economy’s performance in H2 2011, i.e., on whether headwinds prove to be transitory, notably the Japanese effect and gas prices. We still feel QE3 is a distinct possibility in Q4 2011 or Q1 2012 – and sooner, rather than later, in the event of dramatically weaker equity markets. The Fed may, however, decide that a slight modification would dampen the criticism that more QE would inevitably elicit from Congress – they may well decide to ’sterilise’ their purchases of medium and long-dated securities by issuing short-term T-Bills to mop up the liquidity thus created, keeping the balance sheet size constant.

Eurozone Monetary Policy

Having effectively announced it at the post-meeting news conference in March, M. Trichet’s ECB Governing Council duly delivered a Refinance Rate rise from 1.0 percent to 1.25 percent in April, unable to stomach headline Eurozone CPI which rose to 2.4 percent in February and reached 2.8 percent in April.

Not for the ECB, the Fed’s and the Bank of England’s willingness to ‘look through’ the main transient causes of same, e.g. crude oil prices, nor any room to give any concession to the economies of the periphery which are in the throes of still nascent austerity ‘experiments’. The ECB’s one purpose in life – to maintain inflation below, but close to 2.0 percent – is paramount.

In light of this, and having started the tightening process, it seems unlikely that the ECB will stop there. One has to expect that the July meeting will bring another hike to 1.5 percent, as presaged by Trichet’s use of the all-important ’strong vigilance’ code words in the post-ECB meeting conference on 9 June, despite his subsequent rather confusing insistence that the ECB never ‘pre-commits’. Following that, however, the waters will become murkier. As discussed above, the world’s largest economy is slowing alarmingly, and economic releases in the Eurozone have also started to turn down; even power-house Germany saw its Industrial Production figures for April disappoint at -0.6 percent month-on-month; the first drop since December. The consumer also shows signs of flagging and the ECB will be aware of, and pleased by, the widening fiscal squeeze throughout the union. The future path of rates will therefore be heavily data-dependent.

In light of all of the above, we see only a 50 percent chance that rates are hiked again to 1.75 percent, in H2 2011, and add a forecast of a 50 percent probability that rates then pause until H2 2012, depending on data flow, implying lower rates than those forecast by the futures markets.

Japanese Monetary Policy

We maintain our call for unchanged Japanese rates throughout 2011, and indeed also through 2012. As we warned in the Q2 Outlook, vigilance is required with respect to the possibility of massive additional quantitative easing if the recovery from the earthquake and tsunami stalls, i.e. Bank of Japan monetisation of sovereign debt.

U.K. monetary policy

As expected, the Bank of England’s Monetary Policy Committee (MPC) left its base rate unchanged at 0.5 percent at its meeting on 9 June, and we believe that the minutes of that meeting, (due for release on 22 June), will reveal that there is now not one single member of the committee voting for rate hikes, as arch-hawk Sentance has left, and Messrs Dale and Weale will have withdrawn their calls for a 25 basis point hike in light of collapsing industrial production, consumer sentiment and mortgage lending.

Indeed, it is entirely possible that the debate regarding further quantitative easing will have been resuscitated, with the persistently dire warnings of MPC uber-dove Posen suddenly looking very prescient. For example, the IMF has now reduced its 2011 growth forecast to just 1.5 percent, having called for 2.0 percent last autumn. We are now completely confident in our previously rather brave call that rates would remain at 0.5 percent throughout 2011, and would extend that prognosis until end-H2 2012, with a 50 percent chance of further QE in Q4 2011/Q1 2012.

With another day of dallying and dallying outside, perhaps, of GBP crosses, we have a look at the really big picture for each of the G-10 currencies versus a basket of their peers.

With no further ado, the charts below are of each G-10 currency versus an evenly weighted basket of the nine remaining G-10 peers. Each chart is indexed to 100 at 2500 trading days before the present trading day, which is about nine and half years ago. For more on our latest longer term forecasts, please also have a look at our latest FX Monthly for May. Note that data for all charts has been compiled using a Bloomberg data feed.

USD

While the USD index stopped short of new lows for the cycle, we can see against the rest of the G-10, the USD traded to a new all time low before rebounding sharply on signs of a deceleration in global growth, and possibly also as the market mulls the coming end of the Fed’s bond buying program.

What to watch for: the end of QE2 is the dominating factor, as is the status of the USD’s tendency to trade simply as the flipside of risk appetite. When will the crazy good news is bad for the US dollar and vice versa trade come to an end? Mostly the USD seems to only be able to thrive on misery elsewhere, rather than due to its own merits, which are hard to find except when risk appetite is on the defensive.

EUR

The Euro fell a very long way from its exaggerated strength in early 2009 and bottomed out at the beginning of this year at a level not seen since early 2002 when the market was very nervous about the currency as it first entered general circulation in the EuroZone.

What to watch for: In the bigger picture, a lot of worry is already priced into the single currency, so the pressure really needs to line up for the Euro for it to continue falling from here against the broader market. Against the rest of the G-10, the currency may be rather rangebound.

JPY

After an enormous back and forth swing in the wake of the earthquake/tsunami, the JPY has largely gone back to following the lead from the bond market of late.

What to watch for: interest rate direction above all. Separately, Japan has been self-funding its public debt for decades, but that can soon no longer be the case as the first baby boomers begin retiring and the top heavy demographics see an exhaustion of further savings potential. Japan could be the canary in the coal mine on the longer term sovereign debt problem that overhangs nearly all of the developed economies.

GBP

Sterling is interesting as it sits near the lows of the last 10 years, neither able to rally or to sell off further. Volatility-wise and barring a sovereign debt panic, the side of least resistance may be to the upside for the embattled pound.

What to watch for: If the BoE’s view that inflation may be looked through is vindicated in the months to come and risk appetite generally remains rocky to lower, the pound may find a groove and get repriced higher against the more typically pro-cyclical currencies.

CHF

CHF Has been finding upside as the flipside of Euro woes. Note how each surge like the one we are seeing at present fails to hold in the near term, but always seems to be followed by another surge higher eventually.

What to watch for: if the market ever regains confidence in the Euro and the EU gets ahead of the curve on the sovereign debt situation, look out below for the overvalued CHF! Rising interest rates could also weaken the currency.

AUD

AUD has reached yet another high against the broader market of late on its exposure to the Chinese commodities demand juggernaut and on its relatively gaudy interest rate that encourages carry traders as long as risk appetite is healthy.

What to watch for: A Chinese slowdown would be critical for Australia as the mining industry is the only cylinder firing in the Australian economy. The country risks a banking crisis if the housing bubble correction that may be getting under way now and in the coming months gets disorderly.

CAD

CAD has underperformed its commodity currency peers due to its proximity with the US economy and still rather low interest rate, as the BoC is concerned about the CAD’s strength

What to watch for: risk appetite and crude oil prices are critical for the currency, as is the relative strength of the US economy. If rough seas lie ahead for risk, CAD will be a rangebound performer at best in our preferred scenario.

NZD

NZD has been very strong of late, perhaps due to capital flows related to the extensive rebuilding after the February earthquake in Christchurch.

What to watch for: NZD seems to be outperforming its fundamentals, particular If market conditions remain uncertain after the end of QE2. Upside potential may be relatively capped against the rest of the G-10.

SEK

SEK is usually a pro-cyclical currency. As it is a bit of an orbiter of the Euro, it’s potential has been somewhat limited by the poorly performing Euro.

What to watch for: SEK has been very tightly correlated with global risk measures for years, like broad equity indices, etc. It’s upside may be relatively limited if a rough patch lies ahead for the global economy. It is also vulnerable to excesses in the domestic housing market, though it should avoid the kind of panic it saw back in 2008.

NOK

NOK has come off of late as a passive participant in the proceedings, dragged lower by the huge sell-off in crude oil and perhaps to a degree by the weak Euro.

What to watch for: NOK is generally pro-cyclical, but looks too cheap relative to the broader market if it heads much lower. It will be an interesting currency to watch if we ever get a full blown sovereign debt crisis due to the nearly unmatched public balance sheet.

Key points

• EUR/USD expected to rise again and is likely to peak around 1.48
• A gradual increase in US rates should help lift USD/JPY
• GBP will stay weak, as the BoE will postpone rate hikes
• CHF will stay overvalued as the Swiss economy looks strong
• Relative rates continue to favour SEK and NOK
• The commodity currencies are expected to peak in three months’ time

The euro has been the worst-performing G10 currency over the past month as European sovereign debt concerns have resurfaced as a market theme. Also, the massive correction on commodity markets, the fact that money-market pricing of the ECB proved too aggressive and stretched long euro positioning ahead of the ECB meeting have added to the selling pressure on the euro.

Looking ahead, however, we expect relative interest rates to resume their role as the dominant driver of the currency markets. Our economists’ main scenario remains that an early Greek debt restructuring will not find political support within the EU, which should leave the debt crisis contained for now and limit the spill-over to overall risk appetite.

Furthermore, in our main scenario Greek funding problems render the ECB’s hiking path unchanged. As the Fed stays dovish, dollar weakness is here to stay, in our view. Relative rates should also play a pivotal role in driving EUR/SEK and EUR/NOK lower, as both the Riksbank and Norges Bank are continuing their hiking cycles this year. While we look for overall market sentiment to remain intact, the support to the pro-cyclical currencies from risk appetite is likely fading, as our equity strategists look for equities to stay range-bound for the remainder of 2011. Also, it seems like we are nearing a peak in the commodity currencies, as we do not expect a repetition of the past year’s large gains in commodity prices.

Main forecast changes

Lingering concerns about a Greek debt restructuring have left the euro trading with an elevated risk premium. While fears of contagion and a disorderly Greek default have returned to the forefront, our euro economists expect a loan package be extended, easing fears of a debt restructuring being imminent. Given the prospects of the ECB signalling in four weeks that the hiking cycle will continue in July, we therefore maintain our call for EUR/USD to trade higher. However, we have opted to revise our three-month forecast lower to 1.48 (from 1.50), reflecting the elevated risk premium on the euro, as well as the outlook for equities and commodities to range-trade in the coming months. Towards yearend, relative rates should become less of a USD-negative, as the Fed moves towards ending its current loose monetary policy regime. Thus, as time is passing, we have revised lower our six- and 12-month forecasts to 1.46 and 1.38 respectively (previously 1.50 and 1.40).

The collapse in US rates since mid-April and the unwinding of short JPY positions have been key factors sending USD/JPY lower. We maintain our view for the pair to correct higher as our interest rate strategists see US fixed income markets as somewhat overbought and look for US yields to grind higher in the coming months as the end of QE2 approaches. However, with the Fed expected to stay put until well into 2012, the upside potential for US yields remains benign, capping the potential for a higher USD/JPY in the near term. We have revised our three-month forecast lower to 82 (previously 85).

Despite the hawkish BoE inflation report, the hawks in the MPC are facing headwinds: economic data is weak and inflation expectations are easing. We expect the BoE to remain on hold throughout 2011 (see details in UK Research: Ten good reasons why the Bank of England will keep rates unchanged in 2011), causing relative rates to move against GBP. We maintain our call for EUR/GBP to reach 0.92 in three months, 0.89 in six months and 0.86 in 12 months.

The Swiss franc has gained ground as worries over the Greek fiscal situation have intensified. However, it is not only European sovereign debt concerns that are keeping EUR/CHF low. The Swiss economy is favoured by a strong cyclical outlook which, coupled with low debt levels as well as healthy internal and external balances, is keeping CHF strong. The first SNB rate hike has been delayed due to the strong level of the currency and the low inflation rate, but a rate hike is likely to materialise towards yearend. Overall, we therefore expect CHF to remain at overvalued levels for longer than previously anticipated. We have revised our six- and 12-month forecasts to 1.27 (previously 1.33 and 1.35, respectively).

Our forecasts for the scandies are largely unchanged: we look for relative rates to continue to point to lower levels in EUR/SEK and EUR/NOK. Most recently, Norges Bank has hiked rates and signalled that further tightening may be in the pipeline. Also in Sweden, a more hawkish tone from the central bank could become a reality if inflation expectations depart further from the Riksbank’s target. We therefore continue to see value in the scandies due to the continued support from higher Swedish and Norwegian interest rates, although we are likely getting closer to the bottom in EUR/SEK and EUR/NOK. SEK might have a bit more catching up to do, however.

We now look for the commodity currencies (CAD, AUD, NZD) to peak against the dollar on a 3M horizon and then decline to less overvalued levels. While all three are expected to see support from central banks likely delivering hikes in Q3, headwinds are mounting as the dollar is likely to stage a comeback during the autumn when Fed hikes draw closer. CAD should be able to sustain its current strong levels in the near term, on an improving economic outlook and still-elevated oil prices, which our commodity strategists see well supported at USD110 per barrel (Brent). Similarly, most factors remain bullish for AUD but a weakening growth outlook, not least in China, could soon start to take its toll on exports. The outlook for the New Zealand economy after the quake is still uncertain, but NZD should get some short-term support with the prospect of the RBNZ rolling back the February rate cuts soon.

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