MacroScope

The rescue plan put together for Greece by its European Union partners was not working anyway — at least as far as financial market speculation was concerned. But then up pops Axel Weber, Bundesbank chief and European Central Bank governing council members.

Athens, Weber is said to have told German politicians, may need up to 80 billion euros in assistance in the coming years. That’s quite a bit more than the 30-billion euro aid mechanism agreed about a week ago.

Result:  The spread between Greek and German 10-year bonds flew out to a new euro lifetime high. It might also have been helped along by the International Monetary Fund Global Financial Stability Report saying:

Advanced country sovereign risks could undermine stability gains and take the credit crisis into a new phase.

Market analysts, in the meantime, are getting jittery about it all and are keen for the EU’s rescue plan to be used.

They’ll be smashing plates in Athens tonight and it won’t be because it’s Greek national day.  Instead, Greek banks and investors will be revelling at the fact the European Central Bank came to the party with a big fat collateral present.

In December and January the ECB said it wouldn’t change its rules on what banks are allowed to swap for ECB loans, even if rating agencies downgraded Greek debt to the point of financial oblivion. However, with markets threatening to push the cradle of civilisation to the brink of ruin, they have decided that it wouldn’t be such a bad idea after all.

ECB President Jean-Claude Trichet said the ECB would extend looser collateral rules, accepting assets rated as low as BBB-, into next year rather than reverting to its previous A- threshold. Greece is currently rated BBB- by two of the three major credit ratings agencies.

The Greek debt crisis appears to be entering a new phase, in which the country is no longer just waiting to get needed help but getting concerned that others — including euro zone powerhouse Germany — may actually be making it hard for them to recover.

First, there is Prime Minister George Papandreou (right in photo). His concern is that speculators are pushing  the cost of borrowing so high that it is undermining the plans he has put in place  for deficit reduction.  Papandreou is known for being a mild-mannered sort, so any kind of irritability is worth noting.

But Theodoros Pangalos (left), the deputy prime minister and once foreign minister, has no such reputation to hold him back.   He has launched an attack on Germany, saying that a) it is allowing its banks to mess around with Greek bonds and b) that it suits Berlin in any case to let the euro fall.

Greece is a country that has always punched above its weight. Its population, after all, is barely more than Chad’s. But it has rarely grabbed as much attention as now with a debt crisis that has gone as far as having some people predict the downfall of the whole house of euro.

With this in mind, MacroScope has noted two thoughtful new posts on Greece and the underlying issues facing the euro zone.

 First, Willliam De Vijlder, chief investment officer at Fortis Investments,  is taking an economist’s joy at all the various conflicts surrounding the issue — from worries about moral hazard (setting bad precedent for others with a bailout) to income transfers versus economic incentives (German retirement has been raised to 67, Greeks can head for the beach from 55).

The reality of  ‘political economy’  is something that irritates many economists – the ”purists”, if you like. The political element is impossible to model;  it often flies in the face of  textbook economics;  and democratic decision-making and backroom horse trading can be notoriously difficult to predict and painfully slow.  And political economy is all pervasive in 2010 – Barack Obama’s proposals to rein in the banks is rooted in public outrage; reading China’s monetary and currency policies is like Kremlinology; capital curbs being introduced in Brazil and elsewhere aim to prevent market overshoot; and British budgetary policies are becoming the political football ahead of this spring’s UK election. The list is long, the outcomes uncertain, the market risk high.

But nowhere is this more apparent than in well-worn arguments over the validity and future of Europe’s single currency — the new milennium’s posterchild for political economy.

For many, the euro simply should never have happened –  it thumbed a nose at the belief that all things good come from free financial markets; it removed monetary safety valves for member countries out of sync with their bigger neighbours and put the cart before the horse with monetary union ahead of fiscal policy integration. But the sheer political determination to finish the European’s single market project, stop beggar-thy-neighbour currency devaluations and face down erratic currency trading meant the  currency was born and has thrived for 11 years.

Could it be that equity and bond investors are living in the best of all worlds at the moment?

Tim Bond, head of global asset allocation at Barclays Capital, has hinted that they might be. He says that history shows current conditions to be the best for both assets.

 Since 1925, we find that in those years in which GDP was above trend and inflation below trend, U.S. equities have delivered an average 10.6 percent real return, with 20-year Treasuries delivering a 5.2 percent real return. 

David Bowers, the one-time Merrill Lynch strategist who now co-drives consultancy Absolute Strategy Research, reckons policymakers and financial analysts have got it wrong about the credit crunch. It is not a consumer event, he says, it is a corporate one.

As evidence, Bowers’ ASR notes that of the roughly 4 percent decline in U.S. economic growth this year, around 85 percent can be attributed to a decline in the capex and inventory contribution. A similar picture can be found in the euro zone — where some  60 percent of a near 5 percent decline is from corporate. There is less of a case in Japan, but at roughly 40 percent of a more than 6 percent decline it is still a sizeabe chunk.

Bowers believes this huge decline is going to force companies to resume output because there will be shortages.  On the one hand, this will lead to improved corporate cash flows, narrrowing credit spreads. On the other a combination of inventory shortages, supply chain bottlenecks and base effects suggest to ASR that inflation is on the way.

Five things to think about this week:

BOND YIELDS 
- Nominal bond yields have risen across the curve, while term premiums and fixed income volatility are higher in an environment of uncertainty about how central banks will exit from quantitative easing policies once recovery takes hold. Bonds have turned into the worst-performing asset class this year according to Citi and none of the factors which markets have blamed for this are about to disappear. Curve steepening seen in April/May has started to reverse and whether it continues is being viewed as a more open question than whether yields head higher still.

RATTLING EQUITIES? 
- World stocks’ are struggling to extend the near-50 percent gains seen since March 9 but they have yet to succumb to gravity despite a back up in government bond yields. Citigroup analysts reckon global equity markets can rally as long as Treasury yields stay below 5-6 percent but it might be the speed of yield moves that determines whether equities get rattled or keep looking past higher borrowing costs to the recovery story. 

INFLATION EXPECTATIONS 
-  Increases in the prices of oil and other commodities have seen the CRB index rise about 30 percent in less than four months and sustained gains will risk filtering through to prices and price expectations. Inflation reports are due out on both sides of the Atlantic next week but markets are looking further out and starting to price in the risks of a pick up in price pressures. Breakevens have turned positive all along the U.S. yield curve for the first time since autumn and euro zone breakevens have risen. Also, a Bank of England survey indicates public price expectations are up. Bid/cover ratios and tails at inflation-linked bond auctions will tell their own story on extent of demand for inflation hedges.

Five things to think about this week:

VOLATILITY
- World stocks' near-50 percent gain since early March may be levelling off -- investors have factored in much of the output recovery that is in the pipeline and fresh impetus could be needed from further improvements in economic indicators or the corporate outlook. With many fund managers yet to wade in with the cash piles on which they have been sitting, a bout of volatility looks more likely than a dramatic pullback.

GROUP OF 8
- Talk of green shoots of economic recovery has removed some of the threat of global economic meltdown and therefore reduced the pressure to come up with coordinated international policy response. The Lecce finance ministers' meeting will test G8 nations' commitment to putting up extra money for the IMF and an SDR allocation increase. The risk is that cracks appear on these and other issues (eg QE, fiscal stimulus, etc). Given expanded IMF resourcing was one of the planks on which the equity market/emerging market rebound was built, any signs of pullback could fuel volatility and throw up risks for the assets which have benefited most from that rally.

DOLLAR STANCE
- Asian reserve managers' reassurance on Treasuries holdings came in the same week as rumblings of discomfort from some emerging market countries (eg South Africa, Israel) on the dollar's slide and its fallout. Soothing noises from Asia about their dollar-denominated holdings and its FX impact risk being cancelled out by the chatter about international reserve currencies building in the run-up to the first BRIC summit later in June.

You’ve heard of Helicopter Ben Bernanke. What about Bazooka Ben? Barclays Capital strategist Michael Pond thinks it’s time for the Federal Reserve to pull out the really big guns and announce it will buy $1 trillion in U.S. Treasury debt in order to counteract a recent jump in Treasury and mortgage interest rates.

The Fed has already said it would buy up to $300 billion, but this week’s bond market drama suggests that investors are beginning to worry that this isn’t enough.

“We tongue-in-cheek believe that the Fed needs to take the approach from former Treasury Secretary Paulson’s quote at a July 15 Senate Banking Committee meeting that ‘if you have a bazooka in your pocket and people know it, you probably won’t have to use it,’” Pond wrote in a note to clients. “While this didn’t work for Secretary Paulson, as he eventually had to use that bazooka and more, the Fed should try to come up with a big enough number that the threat of that purchasing power alone will be enough to keep rates low. For now, we believe that number is $1 trillion and recommend that the Fed make an announcement soon, rather than wait for its June 24 meeting.”