To let Greece get away with its misdeeds would be to weaken the EMU

Outlook:

The snowstorm lost the label “100-year blizzard” for New York City but in Connecticut, we have a foot so far and it’s still coming down. People who live in really snowy places (Buffalo, Montana, Switzerland) laugh at New Englanders, but it’s not the snow—it’s the fear of losing electrical power. The richest country in the world should have overcome this risk. Does the power ever go out in Switzerland? And somebody needs to breed a dog that will go out in the morning in a foot of snow without the owner shoveling him a path.

We should not be surprised by the euro staging a comeback. One reason for the robust correction is that the recent events were well-signaled in advance—Draghi would do QE, Syriza would win the Greek election. That we do not have panic in the street shows that traders and investors think the parties will be pragmatic and reasonable. And the reasonable next step is for Greece to be given a third bailout with better terms, one that doesn’t include default. Bloomberg refers to the 1953 forgiveness of half of Germany’s war-time debt as a model without addressing whether forgiveness is still, technically, default. If you are the creditor, not getting all your money back sure looks like default.

Besides, we have not even begun the latest round of teeth-clenching. Greece wants to stay in the eurozone and wants debt forgiveness, and Germany says it can’t have both. To let Greece get away with its misdeeds would be to weaken the EMU and induce other miscreants to pull the same tricks (lying about budgets, etc.). We can’t expect a straight-line road to a solution. The FT notes it could get worse before it gets better, saying “the implied 10-year borrowing costs for Athens are up 77 basis points to 9.64 per cent as investors fret that the new Greek government is on collision course with its creditors over renegotiation of its bailout terms. The Athens stock market is down 3 per cent.”

But in mainstream EMU, German Bund yields recovered from the worst case 0.3357% yesterday to 0.39% this morning. Because Greece is such a small country, traders are shrugging it off--so far. The absence of contagion is critical. But contagion is not at all well understood and can always invade when and where we might least expect it.

There are mysterious things going on in various places—threatened Swiss intervention, the PBOC dropping they yuan for two days and then bringing it back up—but the biggest economic problem today remains the persistent fall in oil prices and the implications of that fall. Not the least of the implications is Russia tumbling into an ever deeper hole and refusing to stop digging, but to a certain extent, we already know how that shapes up, even if we don’t know how it ends. Russia gets a crashing economy but has to supply as much oil and gas as it can churn out.

More insidious is the deduction that it can’t be just increased supply behind the drop in oil—it must also be a drop in demand. And if demand is falling, economies must be in more trouble than we think. Who is telling us demand is falling? The IEA, among others. And yet when you search for hard data on demand, none of it incorporates information in alternative energy sources, new efficiencies, per capita comparisons, or other critical metrics that would help us understand what is really going on. See, for example, the mini-chart below.

And the other big implication is how the Fed is going to view falling US inflation as a factor in the upcoming decision about normalizing interest rates. One minute we hear an expert saying conditions will cause the Fed to postpone from June to September, and the next minute you hear some other expert saying that sticking to the plan is a critical confidence factor. The probability of oil back at (say) $80 by year-end is actually pretty high, and surely the Fed knows that. By this time next year we could see scary-high inflation data, and not just in the US—Europe, too.

We expect to see the dollar continue to retreat today and at least until the Fed statement tomorrow. It’s not a new trend, just a correction. Keep your powder dry.