• Greek debt swap-It's on
  • G-20 meeting, ECB LTRO, and month-end ahead
  • EUR short squeeze continues; JPY reversal extends

Greek debt swap-It's on

On Friday, Greece issued the formal invitation to bondholders to exchange their Greek debt for new bonds and take an approximately 75% loss in the process. Without getting into all the nitty-gritty details, the key for us is the rate of creditor participation and what it implies for the risk of a credit default, which would trigger CDS (credit default swaps-insurance on Greek government debt) payouts, potentially rattling global markets' nerves.

Beginning with the most benign scenario, if 90% of bondholders sign on, the exchange will be considered voluntary and CDS will not be triggered. In a darker scenario, if between 75% and 90% of creditors participate, collective action clauses (CAC's) will be used to force the exchange on all bondholders, which would make the exchange involuntary and likely trigger CDS payouts. In the worst case, if less than 75% sign up, the entire debt swap will be scrapped, leaving the second Greek bailout in doubt and increasing the risk of a disorderly Greek default in a matter of weeks.

We have no way of knowing the extent of creditor participation, which makes this an extremely difficult event to call. For what's it's worth, the lead IIF negotiator indicated on Friday he was 'quite optimistic' about a majority of bondholders approving the deal, leaving it open whether it reaches the 75% minimum threshold. In terms of timing, the Greek plan calls for creditors to accept the swap by March 11, or potentially be subject to CAC's.

If the Greek debt exchange triggers CDS payouts, we think there is potential for another wave of financial sector turmoil. The net amount of Greek CDS outstanding (firms who have bought minus firms who sold Greek CDS) is small at around EUR 3.2 bio. But that figure masks the gross amount of Greek CDS obligations outstanding, which is around EUR 70 bio. The risk is that financial sector players react with counterparty panic, unsure of which institutions are on the hook and for how much, possibly leading to a wider market seizure. Stay tuned to the headlines and watch for the participation rates (the total amount of Greek debt open for exchange is EUR 206 bio).

G-20 meeting, ECB LTRO, and month-end ahead

This weekend will see G-20 finance officials gather in Mexico to discuss global issues and expectations are relatively low for any meaningful initiatives. The focus for markets will be on getting new capital commitments for the IMF to strengthen its capacity to support Europe. The IMF has indicated it's seeking an additional USD 500 bio in lending capacity, while the 17 euro-area nations have committed to around USD 200 bio in new capital.

We think there is room for some disappointment coming out of the G20 if significant fresh capital is not committed to the IMF. US, Chinese and Japanese officials, among others, have indicated they want to see further measures from the Europeans themselves before committing additional support. For the US, in particular, providing further aid to the IMF to support Europe is political suicide, so we would certainly not expect any US capital commitments. If the G20 balks and no major capital commitments are made, risk sentiment may get off to a rocky start to the week, but if incoming economic data continues positively, risk appetite should ultimately rebound.

On Wednesday at 0515ET/1015GMT, the results of the ECB's second (and, for now, final) Long-Term Refinance Operation (LTRO) will be announced. Markets are expecting Euro-area banks to draw around EUR450 bio in fresh 3-year financing, slightly less than the EUR 489 bio taken up at the Dec. 22 LTRO. Should banks take up less than EUR 400 bio, we think European government bond markets may be disappointed and we could see yields start to move higher again, which might take some of the wind out of the euro's sails.

If bank demand is as expected, EU debt markets should remain resilient. But there, too, is the risk of a buy-the-rumor/sell-the-fact reaction, where bonds have rallied in advance of the LTRO and are now ripe for profit-taking. As well, following approval of the second Greek bailout and the LTRO, what's the next source of good news to look forward to out of the EU debt crisis, again setting up the potential for a EUR reversal.

Next week also sees the usual month-end portfolio rebalancing flows and we expect to see a bias toward further USD-selling, typically culminating each day in the hours leading up to the 1600GMT/1100ET London fixing. The strongest dollar-sell indications are against the commodity currencies (AUD, CAD and NZD), but also against GBP, CHF and JPY. For the JPY, however, as we discuss below, we would not look to sell USD/JPY.

EUR short squeeze continues; JPY reversal extends

EUR continued to push higher across the board, as the large short-EUR position continues to be squeezed out. CFTC data indicate the EUR/USD net-short position was further reduced to 142K from 148K in the prior week, but the data only covers up to last Tuesday, and undoubtedly shorts were further reduced into the end of the past week. However, the net-short reduction is only down from recent all-time highs of around 170K, so it looks like there is still plenty of room to go.

Additionally, the EUR has been supported by more positive developments in the EU debt crisis, anticipation of the LTRO, and some not so bleak data. Still, we find it difficult to enthusiastically embrace the single currency in light of stagnant growth prospects, especially at levels just below 1.3500. Instead, our preference would be to use pullbacks into the 1.3250/1.3300 (just above the top of the daily cloud) area as a potential long-entry zone, and we remain mindful of the headline risks facing EUR. On the upside, beyond the 1.3500/10 psychological/option resistance/38.2% Fibonacci retracement of the 1.4940-1.2626 decline, the weekly Kijun line comes in at 1.3586.

Last week, we cautioned that JPY-weakness was likely to continue, but the desired pullback in USD/JPY or JPY-crosses never materialized. We think there is still more room to go, but we're also finishing the week around key resistance levels. In USD/JPY, the top of the weekly Ichimoku cloud is at 80.95, and we're still reluctant to chase the pair higher into this key resistance. As well, the US/Japanese 2-year interest rate spread still suggests a USD/JPY rate closer to 78.60/70, so we would suggest patience and continue to look to enter USD/JPY longs on pullbacks into the 78.50/79.50 area.

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