The Week Ahead

Never-ending Greek drama

The week draws to a close with a vote of confidence pending in the Greek parliament around 6 pm EDT/midnight Athens time. In the worst case scenario, if the vote fails, the ruling PASOK party would be forced to engage the opposition New Democrat Party in negotiations to form a coalition government. If the parties are unable to reach agreement, which is not at all certain, snap elections would ensue in three weeks' time under Greek law, leaving the country without a government to formally accept the terms of the EU/IMF bailout package agreed to on Oct. 26. (Possibly a caretaker/national unity government could be formed that could legally endorse the bailout package).

The risk here is that political turmoil within Greece could block the EU bailout aid, leading the government to default abruptly when it runs out of cash in mid-December. A disorderly default would see the euro and Euro-area banks get crushed and a likely global financial tsunami ensue. In the best case scenario, the vote passes and the government is able to receive the bailout funds, removing the threat of an imminent Greek default and potentially triggering a relief rally in risk assets. One way or the other, though, PM Papandreou looks to be out of a job soon, but there are many other potential outcomes in this on-going drama. In particular, should the vote fail, political negotiations could drag on through the weekend, potentially unnerving sentiment if a resolution is not found by Monday's market opening.

While Greece has drawn all the attention this past week, there are other indications that suggest markets are ripe for a potentially significant relapse in risk sentiment. Despite reports of ECB buying Italian and Spanish government debt, Italian yields are at all-time highs and Spanish yields are at their highest levels since August. This suggests to me that markets remain unconvinced that the EU's ostensibly comprehensive solution will actually work for countries 'too big to bail.' 2-year government bond spreads between troubled EU nations (Italy, Spain, Portugal and Greece) and Germany are all at euro-era record highs, offering another vote of no confidence on the EU plan. As well, most risk markets were only able to retrace about 38.2% of the sell-off even after the idea of the Greek referendum was scrapped. So while the Greek tragedy plays out in the foreground, keep an eye on the background of Italy and Spain.

What the central banks didn't do

Adding to the pressure on risk assets is an underlying deterioration in recent economic data, especially in Europe, in contrast to more robust numbers just a few weeks ago. Key Eurozone PMI's fell below the 50 expansion/contraction level and Germany's unemployment rate unexpectedly ticked higher to 7.0%. Perhaps ECB member Yves Mersch summed it up best, saying the economy is practically 'in free-fall,' adding the odds of a recession there are more than 50%.

In response to the weakening outlook, and in an uncharacteristic display of economic reality, the ECB surprised markets by cutting interest rates ¼% to 1.25%. But more important is what the ECB failed to do. Newly installed ECB president Draghi flatly declared that the ECB would not be the lender of last resort for banks or governments and could not stabilize the debt markets of beleaguered Eurozone countries, like Spain or Italy. Without ECB support, debt investors are left looking at highly indebted national governments promising to borrow more to guarantee earlier borrowings, and not feeling especially comfortable.

In the US, October jobs data provided little support for the notion that US growth was picking up momentum, leaving the brief euphoria following the 3Q GDP report as a distant memory. The Fed this week issued downwardly revised forecasts for 2012-2014, expecting anemic growth and high unemployment to persist over the period. In response to this bleak outlook, the Fed did nothing. Bernanke indicated that QE3 remains an option and that it was discussed, but he also seemed to suggest that it wasn't going to happen any time soon. It's unclear what the Fed is waiting for given its moribund economic outlook, but for now expectations for QE3 are dwindling rapidly, providing yet another headwind to risk assets.

Charts suggesting risk assets may take a dive soon

Following on the political and fundamental risk-negatives outlined above, charts across multiple assets suggest there is potential for a possibly serious decline in major risk markets in the weeks ahead. High correlations persist across stocks, commodities and risk FX, so many of the following observations can likely be seen on many other assets, but here are a few particulars to focus on:

•  EUR/USD has formed a bear flag consolidation pattern on short-term charts after the early decline this week and could also be forming a head and shoulders (H&S) bearish reversal pattern following the recovery from below 1.3200. The break down levels for both patterns are converged in the 1.3650/3700 area and both suggest downside targets around 1.3100/50. Strength beyond 1.3950/4000 would invalidate those patterns.
•  USD/CHF has a mirror image bull flag similar to EUR, with the break-up level in the 0.8900/50 area and about a 300 point target to 0.9200/50. A drop below 0.8700/50 would negate that set-up.
•  S&P 500 also sees a potential H&S top forming on intra-day charts, with a break below 1215/1220 targeting a move lower to 1140/45. Strength above 1255/60 area would void this set-up.
•  Gold (XAU/USD) appears to be in an ascending wedge (bearish reversal pattern) and possibly stalling below key Sept. break-down levels at 1760/65. A drop below 1715/20 base of the wedge may see lower to the 1650 area.

Finally, we would note that with interventions in JPY and CHF, the USD is the go-to currency if risk sentiment collapses.

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