By Matt Hedrick
November 2, 2011

When I was in Greece in late September I remarked to my cabbie on the 35 minute ride from the airport to downtown Athens that there was astonishingly very little traffic as we approached the city center. His answer: Greeks can’t afford to fill up their tanks. At the time, gas prices were at €1.71/litre, among the highest in Europe given the government’s added gas tax.

It’s clear that austerity is hitting the Greeks hard. And for an economy highly dependent on tourism, you can bet all the strikes, riots, and government indecision have chased away a number of tourists.

Austerity’s bite alone doesn’t justify Prime Minister George Papandreou’s decision to call a confidence vote on his party and referendum on the newly-minted (though rough) framework for a second bailout of Greece. Frankly, neither Papandreou nor the Greek Parliament has been calling the shots on the country’s future policy over the last eighteen months. Eurocrats have — in particular the Germans from Chancellor Angela Merkel’s podium. However, now Papandreou’s actions threaten to create further outsized market risks as he reaches out to the people, rather than Brussels, for direction. This is a reckless decision.

Below are the important developments and our take on the impact of Papandreou’s actions on the market and common currency:

Papandreou’s Party is on the Brink: The confidence vote that Papandreou called was a very risky (and ultimately victorious) maneuver, but it’s not clear how long he can hold onto his lead. A crisis meeting between Papandreou, French President Nicholas Sarkozy and German Chancellor Angela Merkel is expected later today, as Brussels was largely blindsided by Papandreou’s announcement, which led to an extreme plunge in European equities and a hit to the euro. Could Merkozy somehow force Papandreou to about-face and undo his action? It seems unlikely, but we can’t completely rule it out either.

Despite the diplomatic statement from European Council Herman Van Rompuy…

“We take note of the intention of the Greek authorities to hold a referendum. We are convinced that this agreement is the best for Greece. We fully trust that Greece will honour the commitments undertaken in relation to the euro area and the international community.”

… realize that Papandreou’s move is a slap in the face – after all, the EU, IMF, and ECB have worked to support Greece, most recently at the EU Summit.

Debt Referendum Stretches the Window: Papandreou’s call for a referendum on the terms of the second bailout of Greece (€130 Billion), which is being called for the beginning of Dec. 2011 or Jan. 2012, heightens the already tenuous state of the Greek state. It elevates the prospect of a Greek default/exit of the Eurozone, and could stretch concrete decisions on the expansion of the EFSF, recapitalization of European banks, and haircuts on Greek debt. More concretely, the bailout tranches that Greece receives from its original bailout could be put on hold, which could ground the country further to a halt or default. Any way you slice it, little good can come from the actions taken by Papandreou this week.

Square in a full Calendar: On the theme of blindsiding Brussels, the timing of Papandreou’s announcement is complicated by the G20 beginning on Thursday in Cannes, at which the market is expecting more exact details on the rough framework outlined at the EU Summit, including how the EFSF will be reinforced and details on bank recapitalizations and the write-down of Greek debts. Further, the ECB convenes on Thursday to announce its main interest rate policy. We expect no change, yet the timing of the decision adds further market consternation. This is all on the backdrop of slowing growth (Germany and France revised GDP for 2012 down to 1.00%, vs previous estimates of 1.80% and 1.75%, respectively), declining PMIs for Services and Manufacturing [most in contraction territory (sub-50) over the last months], and stubbornly high unemployment across the periphery.

Common Currency Weakness: We don’t expect a rate cut on Thursday’s meeting, which may bring some support to the currency. Not only do we not see Mario Draghi making a big splash in his first week (his first day as ECB president was on Tuesday), but inflation still remains elevated at 3.0% (above the ECB’s mandate of 2.0%) over the past two months. We do think the ECB will cut over the intermediate term, perhaps as soon as next month, as slowing growth concerns elevate. We’re looking to re-short any immediate term bounces in the EUR-USD.

Risk Signals: Markets are extremely volatile, running off the next headline or rumor, as the game changes with nearly every Eurocrat sound bite. We’re keying off risk signals from Italy, namely the all-time wide in the spread between 10-year German bonds over Italy 10-year yields, at 118 bps, as a signal that Europe is far from reaching any resolution on its sovereign and banking crisis. Italy, with a public debt of 120% of GDP, poor leadership, lack of resolve on its austerity package, and considerable banking risk, remains a far larger shoe that could drop in this European soap opera and stoking the larger fear trade we continue to see play out.

And a stiff glass of ouzo is not going to cure these ails!


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