Liquidity Lifts Markets as Greece Worries Loom

AMSTERDAM—Uninspiring economic data coming out of Europe was overshadowed by developments in Greece and enthusiasm over the European Central Bank’s (ECB) liquidity provision.

Inflation in the form of the eurozone CPI for December came in below expectations. Prices increased 0.3 percent, while a rise of 0.4 percent was expected. However, this marks acceleration from the increase of 0.1 percent in November.

An increasingly weak euro is helping European exports. The trade surplus for November increased from 1.1 billion euros ($1.42 billion) to 6.9 billion euros ($8.89 billion). This more encouraging data did not prevent the World Bank from issuing a report that the euro area entered a recession in the fourth quarter of 2011.

European Financial Stability Facility (EFSF) Downgraded

Standard & Poor’s (S&P) credit rating agency followed through with its tough stance on European sovereigns and downgraded the supranational entity EFSF.

The conduit was initially supposed to lend to troubled sovereigns and the purchases should have been funded by issuing EFSF bonds, which are guaranteed by eurozone members. However, the facility could only issue 22.4 billion euros so far in the market and heavily depended on the AAA-rating of some of it guarantors like France and Germany.

Since France and Austria lost their AAA rating two weeks ago, S&P also proceeded to lower the EFSF rating from AAA to AA+ citing that “the EFSF’s obligations are no longer fully supported either by guarantees from EFSF members rated AAA by Standard & Poor’s, or by AAA rated securities.” Given the liquidity provisions of the ECB recently and the announcement of the European Stability Mechanism (ESM) at a EU summit in December, the EFSF is unlikely to play a major role anymore.

Greece in Spotlight Again as Default Looms

Despite the countless times that Greece was already rumored to be going into actual default, it has not happened so far. However, tension is increasing and talk is getting tough. “Greece is insolvent and will default on its debts,” Fitch Ratings Managing Director Edward Parker said.

The country faces a March 20 bond payment of 14.5 billion euros ($18 billion) and does not have the money to service it. Talks have been ongoing to arrange a deal between private creditors and the debt-ridden country to make the debts more manageable and avoid a hard default, but Parker does not believe in voluntary restructuring. “The so-called private sector involvement, for us, would count as a default, it clearly is a default in our book,” he said.

According to the Financial Times, one participant said that excessive demands by the International Monetary Fund (IMF) could have put a voluntary deal out of reach. If the deal is not signed in time and the paperwork and legal framework established, Greece will default by March 20.

Markets Up for the Week as Liquidity Abounds

The euro rallied from its oversold position and gained a solid 2 percent to close at 1.2931 last week. Equities were also up despite the less-than-encouraging data, downgrades, and the problems in Greece.

Equities rallied 3.8 percent to 2,426 for the EuroStoxx mainly due to a reduction in what statisticians call “tail-risk.” The massive provision of liquidity by the ECB has reduced the likelihood of a banking failure occurring and that has benefitted equities, says Richard Koo of Nomura in a recent report. “Under the ECB’s long-term repo operation (LTRO), announced by incoming President Mario Draghi last December, the Bank agreed to supply an unlimited quantity of three-year funds at an interest rate of 1 percent. The program reassured eurozone market participants by substantially reducing the risk of sudden financial institution failures due to liquidity problems.”

He is more skeptical as to the long-term effects of this operation. “That noted, I think the LTRO is largely a means of buying time and does little to address the underlying issues. More important, most of the funds supplied by the ECB remain with the Bank in the form of deposits and have not flowed into the real economy.”

The Week Ahead

Apart from the meeting of European finance ministers looking to find a comprehensive solution for Greece, several interesting economic data points are going to be released.

Eurozone consumer confidence and PMIs are expected to remain in recession territory. Spanish retail sales are also forecasted to decline, but less so than during the previous month, whereas unemployment is expected to increase even further.