My Diary 696 --- The Growth Contagion Risks to Asia; Let Germany

My Diary 696 --- The Growth Contagion Risks to Asia; Let Germany Talk to Japanese; Data to Confirm No-Hard-Landing; It is about USD again.

Sunday, October 16, 2011

“Ready for Rally or Rally for Rally” --- Risk assets (MXWO +5.4%, CRB +4.1%, BDIY+8.7%) staged a strong rebound from their 2yr lows in the past week, driven by positive cues from Europe and US. Announcements by German and French governments of a potential plan to recapitalize European banks, combined with a sense of ST market stability, have forced investors to start deploying the above-average cash levels they had built up over the months. In HK, sectors that had been sold off the most earlier, such as metals, cement, transport and banks, all outperformed and repeated the similar “junk rally” saw in March 2009. While the policy-maker responses, particularly the liquidity injections, can help to calm the market via a reduction in volatility (VIX -22% from 36.2 to 28.2), I remain wary of seeing this as a turning point for bull rally. Rather, I think investors should use this opportunity of a bounce in the market to reduce illiquid exposures. Broadly, I view the moves as being dominated by short-covering rather than a more fundamental shift, with the LIBOR/OIS and, especially, EURIBOR/EONIA relationships signaling no material improvement in funding, which remains the primary contagion channel.

In order to make the rally sustainable, we probably need the Europeans to pull a few rabbits out of the hat. I still suspect they'll ultimately disappoint as so many different schemes for EFSF and recapping banks are being mentioned without any evidence that one is winning out. As a result, investors ' view on markets at the moment largely depends on how much faith you have in the more urgent words used by European politicians this week. That said, t he approach of European policy makers is still fraught with significant execution risk, and the recent focus on bank recapitalization still deals with the symptoms rather than the cause. Meanwhile, the US ECRI WLI deteriorated further to -8.1% in the week ended 7 Oct from -7.2% the previous week, highlights the increasing fragility of global economy . The VIX Index still stands at ~30%, signaling fragile market conditions. As for fund flows, EM bond funds have lost a total of USD4.7bn over the last few weeks, with both hard-currency and local-currency EM bond funds seeing outflows, suggesting investors increasing nervousness on contagion risks to EMs. It is going to be an interesting few weeks ahead to see whether faith or cynicism wins out.

Looking back, m acro issues have been driving markets for several years and their impact reached near all-time highs in Sep 2011. Whether it's a volatile business cycle, earthquakes in Japan, moderating growth in China, high UNE / weak property market in US, or sovereign debt issues in Europe, macro issues have become important considerations for investors. Thus, it is important to have a top-down analysis when we step into 4Q11. Indeed, the global economy’s movement through Q3 incorporates an important transition. In 3Q11, global GDP likely posted 2.7% growth (+1% above Q2), with +2.5% in US. Large 1H drags caused by rising commodity prices and the Japanese earthquake faded from the scene, promoting lift on the back of stronger consumer spending and a bounce in Japan. However, the recent growth pickup was tempered by the aftershocks from these drags, including a slowdown in labor market and an inventory correction that is expected to weigh heavily on global industry for some time to come. Combined with an abrupt sentiment shock related to a lack of policy competency and confidence, global growth momentum is expected to falter again in 4Q11. One interesting phenomenon is the divergence between current hard activity and survey data – 1) Even excluding Japan, global production gains are tracking a 4.7% increase this quarter, well above the level suggested by global PMI survey, which has moved significantly lower since midyear, and its September level is tracking 1.8% gains; 2) US retail sales (1.1%) rebounded smartly as Q3 ended, despite the collapse in consumer confidence (UoM 57.5); and 3) the major force weighing on growth in Q3, the tightening in financial conditions from the slide in consumer and business confidence, remains in place. Some sell-side economists anticipate the drag from this force will be large enough to throw Euro area into recession and limit US growth to 1% in coming quarters.

Beside the economic fundamentals, the roadmap of finding a solution for EU debt crisis continues to drive the risk appetite. European leaders appear to be reaching a consensus on a three-pronged plan that includes a deeper restructuring of Greek debt, a region-wide bank recapitalization, and a levering up of EFSF to provide support for sovereign financing needs. Important disagreements remain on the size of the Greek haircut (at least 50% + more PSI), with France, ECB and European Commission arguing against anything that would trigger CDS, but the means by which the region will move forward appear to be broadly decided. A consensus looks to have been reached on recapitalization, where banks will be given some time, perhaps six months, to recapitalize on their own before governments intervene with mandatory convertible capital. In addition, it now looks likely that EFSF will be levered via the provision of insurance rather than by converting it into a bank. Essentially, unused government guarantees underpinning the EFSF will be used to provide first loss guarantees to underpin primary issuance for sovereigns that have lost market access.

However, agreement on principles does not imply that the plan will have sufficient firepower to meet all the potential liquidity needs. Given the commitments EFSF has already made to the periphery, there is only about EUR275bn available for leverage. Around EUR200bn of this would be needed to cover Italy, Spain and Belgium’s gross funding needs for three years and their need for bank recapitalization, if they were to lose market access and the EFSF were to provide a first loss guarantee of 20%. That would leave only EUR75bn to provide secondary market support to sovereigns, to provide guarantees to bank senior bond issuance if funding markets don’t reopen, and to guarantee Greek debt so that it was still acceptable to the ECB in repo transactions. This might be sufficient, but it is not exactly a bazooka. Almost certainly the region will require ECB to be prepared to expand its SMP significantly if needed. This support is by no means assured. In an interview, outgoing president Trichet said that it would be inappropriate for the ECB to act as a lender of last resort to governments. As a result, the issue of sufficient firepower has turned attention to the IMF. This would involve more resources from countries such as China and Brazil, which could provide funds to the IMF on a bilateral basis. It should be recognized that a comprehensive plan that successfully contains sovereign stress will still produce a significant tightening in Euro area financial conditions. The plan will impose losses on banks that need to deliver in any event, and the recapitalization process will likely accelerate this deleveraging process. In addition, significant fiscal tightening will be taking place across the region, and countries will be under intense pressure to implement structural reform and to improve competitiveness. Thus, even if the sovereign stress is successfully contained, the macro outlook is troubling.

To global monetary policymakers, the dramatic recasting of macroeconomic and financial market landscape over the past few months has prompted a course adjustment. In DMs, the major central banks already have taken new steps to ease policy. The latest FOMC meeting minutes suggested it is prepared to take further action at the Nov 1-2 policy meeting, changing communications to more explicitly tie guidance on the policy rate to economic conditions and to the Committee’s forecast of those conditions. In EMs, a handful of central banks have joined their DM counterparts with modest easing moves, led by Brazil. Monetary easing is likely to become more widespread in coming months. Having said so, the magnitude of global monetary easing almost by definition will turn out to be quite limited. Effective DM policy rates stand at just 0.80%, with only ECB and BoE, among the largest central banks, having any room to trim. In EMs, policymakers are balancing competing concerns about the outlook for growth versus inflation, limiting their willingness to ease. Although EM currencies generally have strengthened the past two weeks, they are nonetheless down sharply since early August. FX depreciation is an added restraint on policy, as it both feeds inflation and supports growth (with the opposite effects in the DM).

Consequently, the likelihood of an easing in EM policy sufficient to deliver a much stronger EM growth outcome—and thus a meaningful cushion to DM growth—appears low. More importantly, Asian central banks, which manage policy for over 50% of EM GDP, certainly have not taken their eyes off of inflation. To be sure, Bank Indonesia surprised with an ETE 25bp move this week. However, Indonesia is not a leading indicator for the rest of the region, and I do not look for easing elsewhere in the region. Also this week, Singapore’s monetary authority kept the slope of the policy band on a tightening path, while the Bo K left rates on hold. In India, this week’s inflation report suggests RBI will hike one last time by 25bp on October 25. Likewise, China’s inflation remained at an uncomfortably high 6.1% in September. Although inflation will decline into year-end, the central bank is unlikely to lower rates barring a downside surprise on growth.

X-asset Markets Thoughts

On the weekly basis, global stocks jumped 5.41%, with +6.03% in US, +2.84% in EU, +1.85% in Japan and +4.49% in EMs. In Asia, MXASJ closed up 5.48% and MSCI China +6.01%, while CSI300 +2.81%. Elsewhere, 2yr USTs lost 2bp to 0.265% while 10yr +17bp to 2.25% and 30yr +21bp to 3.23%. Yields widened across the Euro area periphery with Greek, Spain and Italy 2yr yields +645bp, +30bp and +23bp, respectively. The 3M Euribor-OIS added 3bp to 74bp. Brent crude rallied 9.1% to $115.50/bbl. The USD gained 3.77% to 1.3882EUR and 0.6% to 77.2JPY. CRB gained 4.08% to 317.18, while Gold price was up 2.82% to $1679.2/oz.

Looking ahead, the durability of this rally depends on a clear solution to the euro area debt crisis and the performance of the global economy. I personally remain skeptical about how much (bank recaps and increased firepower) can be delivered quickly. In fact, today G-20 finance ministers announced no details on the policy program required to contain the European sovereign funding crisis. On FX specifically, the passage eschewing disorderly exchange rate movements and excessive volatility is identical to the last communiqué and the G-20/G-7's longstanding line on this issue. Thus, e vents in Europe will continue to dominate the global calendar. After the G20 FM meeting in Paris this weekend, discussion about the Euro-area debt issues will continue at the EU Council summit on 23 October, and will likely remain the focus of the 3-4 November G20 summit in Cannes. No clear breakthrough in resolving the sovereign debt issues is expected, despite more talk about the recapitalization of European banks, leveraging up the EFSF – which ECB opposes, and a new plan for Greece that may involve greater PSI in the ‘voluntary’ debt swap and a bigger 30-50% haircut. In addition to debates on the European sovereign debt issues, the market will monitor the funding activity of several European governments in the coming week. Greece is scheduled to auction bills on 18 October, followed by the Spanish Treasury selling bonds on 20 October. Also of interest will be the extent of ECB weekly bond purchases: their pace has slowed in recent weeks, with only EUR2.3bn of purchases settled in the week ending 7 October 2011. As a result, I continue to expect a new leg higher in DXY (76.62) as rising financial volatility hits global business confidence, triggering further capital outflows from Asia Over the coming 1-2 months.

That being discussed, the current business and market sentiment is very cautious, with fears that the European crisis will push the world towards recession. But DM economies are still growing, albeit slowly, and EMs remain solid. My base-case view is that a new recession will be avoided, but there is no doubt that the risk has risen. Market confidence could pick up slowly as economic data continues to defy the worst fears and Europe gradually puts in place more measures to strengthen its banks and weak sovereigns. Looking forward, the d eteriorating economic conditions indicate that the balance of risks for equities is to the downside in the next few months. I think investors should U/W equity & commodity, OW cash and NW USTs within a global multiple asset portfolio. For EM equities, while valuations appear attractive, earnings are the key driver in the near term, along with the economic outlook. In case of a renewed recession, the 12M FWD earnings for global equities is projected to be around USD22.50/sh (20% below consensus). As a reference, 12M FWD earnings bottomed at USD17 in early-2009. Factoring in DY, the projected equity loss would be 17%, assuming a 9X FWD PE, comparable to the 2008 low. For the S&P500, assuming EPS12 = USD82.50 and a 12M FWD PE ratio=10X (the 2008 low), the two produce an equity market loss of 19%, taking the index back to the 900 range.

The Growth Contagion Risks to Asia

The macro schedule for US was light last week with BTE advance retail sales (+1.1%) and slightly lower initial jobless claims (4WK MAVG remains >400K), while UofM Confidence (57.5 vs. cons=60.2) fell short of expectation. The FOMC Minutes posted no surprise, leaders continued to have considerable uncertainties on US economy. The key to watch will be Bernanke’s speech on 18th October at Boston Fed. Meanwhile, the Senate rejected the President’s economic stimulus bill in a close vote. There remains the possibility of an agreement on individual items in the plan, or on other proposals. However, Washington policy analysts continue to believe most of the fiscal tightening that is on the books for next year (close to 2% of GDP) is likely to happen. In particular, though the consumer “hard” data beat the consumer “soft” data in 3Q11, what consumers say hasn’t changed in the last three months. They are very downbeat about the outlook, witnessed by consumer expectations sub-index at 47.0 vs. 49.4 in Sep, of which it has fell back below the Great Recession low to the fifth lowest reading on record. For reasons, the survey reported that “...an all-time record number of consumers cited income declines and have lost confidence that corrective economic policies will be forthcoming anytime soon…”

With weakening external demands from G3, evidence of slowing growth is increasing in Asia since 2Q11. IMF this week cut its forecast for this year's expansion to 6.3% from an April estimate of 6.8%. China’s Sep exports and imports skidded, along with a modest drop in the nominal trade surplus ( USD14.5bn) in 3Q versus 2Q. Exports climbed a WTE 17.1% yoy in September, with the growth of exports to EU slowed dramatically to 9.7%yoy from 22.3% in Aug. Exports to other destinations held up relatively well (15% yoy for exports to US and over 20% to most Asian countries). The decline in exports fits with a host of EM Asian data showing that export and manufacturing activity is no better than sluggish across the region. EM Asian manufacturers appear to be struggling to complete inventory adjustments engendered by the lengthy stretch of weak global demand growth. Amid at the potential growth contagion risk, Asian financial markets could see further draw-down in the coming quarters. In fact, since 2009, investors from DMs have built up substantial positions in Asian markets. A sudden liquidation of these positions could trigger a loss of confidence, and contagion could spread from bond and equity markets to currency and other markets. In September alone, EM Asia stock markets lost a total market cap of USD1.2trn, about 1/10 of the regions GDP last year. IMF also warned that contagion could also occur through Asian currency markets, as long and carry-trade positions are unwound. A loss of liquidity in cross-currency swap markets -- as in 2008 -- could be particularly disruptive and spill over to bank funding, as many banks rely on this market to fund dollar assets or to meet regulatory currency matching requirements, notably in Korea and Japan.

That said, Asian policy makers are faced with a “delicate balancing act” to guard against risks to growth while limiting the impact of inflation. According to IMF, inflationary pressures across the region are still “elevated” and financial conditions remain accommodative in most of Asia. This week, the Philippines unveiled a USD1.7bn stimulus package as its officials cut growth forecasts for 2011, while Indonesia’s central bank unexpectedly lowered its BM rate this week for the first time in more than two years. In general, I believe that our region can still stimulate itself out of a deep recession, given that – 1) a solid fiscal positions with most Asian economies are sitting on public debt of less than 60% of GDP, well below the G3 85-200% levels. While the fiscal deficits of India, Malaysia and Vietnam are running at 5-6% of GDP, others are at 3% or below, and Hong Kong, Indonesia, Singapore and South Korea are in surplus; 2) EM Asia’s monetary muscles are still strong, though nominal interest rates across the region are now lower than in the pre-Lehman period, leaving less room for rate cuts than before. But with absolute NPL ratios at or below 3%, most Asian banking systems are healthy to support another round of monetary expansion; and 3) the large FX reserves in Asian could serve as a major shock absorber. While all eyes are on China’s massive USD3trn FX reserves, their 51% share of GDP is only marginally higher than the 46% average of the other 10 Asian economies, and remains far behind the 90-120% levels of Taiwan, Singapore and Hong Kong. Surely, a bigger constraint to monetary stimulus is the expanded B/S of Asian central banks and rapid monetary growth in many economies. Over the past three years, broad MS in China, Malaysia, Singapore, Taiwan, Thailand and Vietnam has increased by 20-50% of GDP, mostly as a result of the post-Lehman monetary stimulus.

One thing to bear in mind that EM Asia is far from the world’s savior of last resort. In 2010, EM Asia (accounted for 37% of the worlds USD5.1trn output growth. Half of Asian contribution came from China, which added USD888bn to the worlds incremental output, the same as the contribution of G3 (US, EU and Japan). However, in absolute (not incremental) output terms, Asia – including China – accounted for only 18% of the world’s total last year, or less than 1/3 of G3. If the G3 economies suffer another recession of the same magnitude as 2009, or a 5.8% decline in GDP, Asia would have to boost its output by 17% to offset the G3 output loss. This is a tall order. Even if Asia managed to achieve this, the kind of stimulus required would likely cause serious economic distortion. For example, China is suffering now from the effects of its mega-stimulus over the past three years.

Let Germany Talk to Japanese

As discussed above, the financial markets mood swings will continue to be dominated by the EU development, with the expectation that the ongoing G20 meeting would come up with further solution on the current crisis by 3rd November. However, the S&P’s further downgrade in Spain (Spain’s 10yr yield +25.6bps to 5.24%) and Fitch’s downgrade in UK banks have once again highlighted a heightened systemic risks in the Euro zone, as pointed out by the out-going ECB president. With combined outstanding debt between Italy and Spain at USD2.7trn, the recent selloff in Italian and Spanish debt poses a serious threat to the global banking sector stability, the Euro zone in particular. If Italy or Spain ever reaches to a point where they have to repudiate on their debt obligations, the impact on the global banking system and the world economy would be catastrophic.

Unfortunately, the EFSF, in its current form and size, is toothless in stemming the spread of the crisis. The size of the bailout funds available must be dramatically increased to make it credible. In reality, there are only three ways to augment the EFSF—1) To ask EMU member countries to carve up additional funds, which will prove to be politically difficult, if not impossible; 2) To allow the EFSF to draw in private savings by issuing bonds. This is doable, but must be done in connection with a guarantee from ECB; and 3) To lever up the EFSF on the ECB’s balance sheet. Among these three ways, ECB monetization is the most convenient, effective and low-cost way to sharply enhance the EFSF’s capability. The only “side effect” or consequence of this operation could be a much-weakened EUR and a possible rise in inflation. This is why the Germans remain vehemently against using the ECB to fend off the crisis, given the country’s long-held memory of hyperinflation during the Weimar Republic period.

Nevertheless, forgotten is that printing money does not always mean rising inflation, especially when an economic system faces the serious threat of debt deflation? In the mid-1990s, BOJ opted to monetize a large portion of JGBs to finance the government's efforts to recapitalize Japanese banks. The concern at the time was also hyper inflation and a collapse in JPY was thought to be inevitable. In reality, Japan has never seen inflation rise. Instead, deflation has prevailed and bond yields have fallen sharply and now below 1%. The irony is that Japan’s public finance picture is worse than any country in Europe: the Japanese public sector debt-to-GDP ratio is 233%, debt service costs have far exceeded nominal GDP growth for 20 years and the country has run 18 consecutive years of huge public sector deficits. Nevertheless, while JGB yields are barely 1%, Greece has to pay over 23% for similar bonds. Why? The answer lies with the nature of the Japanese public sector debt and BoJ policy. Japan has no foreign currency debt and the entire government’s liabilities have been denominated in JPY, which has allowed the central bank to be the ultimate guarantor of the solvency of the Japanese govt liabilities.

The situation facing the Euro zone is very similar. Most of public sector debt is denominated in EUR, which means ECB has the same capability as BoJ to monetize Euro zone public sector debt. The only difference is that BoJ serves one national interest, while ECB has 17 members with different views and conflicting national interests. The ECB’s hands are tied—as a result, its ability to defend the banking system has not only been in doubt, but trodden upon by the markets. It is frustrating to see German Finance Minister Wolfgang Schäuble ridiculing US proposal to lever up the EFSF on the ECB’s balance sheet as “stupid”. It seems he may only need to talk to BoJ governor to learn something from history. Until recently, both the German and French economies had held up reasonably well. However, the intensifying crisis in Euro zone and the rapid shrinkage in business activity in the crisis stricken economies have badly shaken investor and consumer confidence in the core European countries, causing their economies to shrivel. With intra Euro zone trade accounts for over 60% of German foreign trade and a big chunk of the euro zone economy relapsing into recession, a recession in the German economy is just about time.

Data to Confirm No-Hard-Landing

The HKEx traded China stocks rallied + 7.85% over the week on the back of ---1) Huijin’s announcement of buying Chinese banks which helped to drive the largest component of the index-H Finance Index up over 10%; 2) a slightly lower than expected CPI number at 6.1%-this together with WTE trade data had led the market to speculate no more tightening measures; 3) State Council said that they would encourage lending to SME-this is nothing new but the definition of SME is the key; 4) 2.81% rally in CSI300. Some analysts have been argued the sell-off in September is overdone, given that insider buying doubled to USD3bn per month in 3Q11 and tripled to USD4.6bn in September vs. the monthly average of USD1.5bn in 1H11. However, what makes me feel interesting is the structure of the recent sell-off among sectors --- Financials, industrials and materials were de-rated on average by 60% vs their 5yr averages, while consumer and IT were down roughly 20%. This divergence suggests a well-recognized investment theme and the real driver of future growth in China: consumption.

That said, macro data were heavy last week with Sep CPI @ 6.1%, in line with expectation and PPI@ 6.5%, lower than cons 6.9% and Aug 7.3%, a positive for corporate profit margins. Sep RMB new loans amounted to RMB470bn, the lowest monthly reading this year and 21.1% less than the same month last year. Historically, banks usually extent credit vigorously at the last month of each quarter to boost the performance in quarter end internal assessment. In Sep, RMB deposit increased by RMB730.3bn, almost 50% less than Sep2010. In the first 3 Qs, M1 growth dipped to 8.9% yoy (vs.20.9% in Sep2010) while M2 growth retreated to 13% yoyo, approaching the historical trough of 12.9% a decade ago. However, if we added O/B/S items back, it would boost M2 growth by around 4-5%, meaning actual money supply is not that tight. As result, I expect policymakers are unlikely to reverse current monetary tightening stance. Instead, they adopt targeted easing to address the micro distortion. The latest move is a set of measured by the State Council to encourage banks to lend to micro and small business and reduce the tax burdens on them.

Looking forward, China economy could follow a gradual and mild slowing trend with steady growths of retail sales and property investment. Meanwhile, due to the residual effect of four-trillion stimulus and super-high lending expansion in past two years, it might take a LTE for the GDP growth and inflation to decline to the “turning point” level where the authority will change the current macro policies. The bear view is that China’s growth could fall to 5% next year. This is an extreme view which requires a global recession with US and Europe GDP falling > 3% below forecast. To give this perspective, the last time China grew at 5% was in 1989-90 due to China’s failed price reform and Tiananmen Square. I still believe in a possible soft landing for China economy in next two years although some risk factors do exist, such as the European and US sovereign debt problem, and the final outcome of this round of tightening policies. That said, the estimated total government debt is ~76% of GDP including contingent liabilities such as AMCs, Policy Banks, Ministry loans, unfunded medical and pension funds and local gov’t debt as defined by the PBOC. Thus, Chinese debt maybe higher than perceived, but the government still has much flexibility to support the economy.

Next week, the market’s main focus of attention is likely to be China again. Along with the Q3 GDP number to be released on 18 October, several other September indicators, such as IP, FAI and retail sales are due to be reported. While exporters will suffer in 2012, we think that the market is underestimating domestic growth and the room for policy loosening. The real-estate and shadow banking sectors need to be monitored, but the actual levels of distress seen so far appear to be very limited… Lastly, regional wise, MSCI China is now traded at 9.0XPE11 and 18.4% EG11, CSI 300 at 12.2XPE11 and 23.4% EG11, and Hang Seng at 9.4XPE11 and 22.0% EG11, while MXASJ region is traded at 11.1XPE11 and +7.8% EG11.

It is about USD again.

It looks to me that the current recovery in risk, the associated improvement in risk currencies and broader weakness in USD can continue in the very short term. But I am also cognizant of the fact that conviction remains low. With year-end quickly approaching for many professional investors, the incentives for preserving capital are increasing relative to establishing risk positions. In other words, if markets turn more risk averse for any reason (weak jobs data, concerns about Europe, newfound EM growth concerns, US fiscal backdrop, etc.), the recent improvement in risk currencies and weakness in USD will quickly reverse.

Yes, it looks difficult to determine the extent to which FX market will respond to "traditional fundamentals" such as growth and interest rates, or whether risk appetite will be the more dominant market influence. The experience of the past four years, and the market's behavior in the past two months suggests to me that risk appetite should ultimately be the driver for USD, once markets get past the immediate post-data volatility. In that regard, data that outperforms expectations and paints a less dire assessment of US economy should be positive for risk assets and risk currencies, and ultimately work against USD. Alternatively, notably weak data will, for a time, leave equity markets more vulnerable, particularly given the +11% rally in S&P500 MTD. And that would likely work in the USD's favour...unless or until it boosts expectations for another round of Fed QE. If those latter sentiments become more prominent, it should help stabilize risk and work against the USD.

That being said, although USD liquidity pressures in the global system are stabilizing for the moment, I remain concerned how these could still pose a downward risk to Asian currencies and how such currency movements could suddenly turn very illiquid. I need to see the demand for USD liquidity reduce significantly before Asian currencies can sustain a more convincing recovery. Importantly, investors need to monitor cross-border liquidity in the financial sector. A persistent concern is that the stresses in the Eurozone could eventually filter into Asia, in particular via sharply reduced cross-border lending. While this is a real risk, Asia's external B/S is more fundamentally resilient today. The key safety valve comes in the form of Asian central bank reserves, which would match excessive USD demand. Without this, the withdrawal of USD liquidity, could pressure Asian currencies aggressively lower in less liquid market conditions, and the risks would then be skewed more towards disorderly USD-Asia movements like what happened in 2008.

With respect to Oil, I think its near-term risks are high. The key obstacle to stabilization in oil prices is risk-aversion induced USD strength as discussed. The strong correlation between oil prices, the DXY index and the S&P500 index underscores that liquidity has been a key driver for oil prices since early 2009. Thus, policy “foot-dragging” opens the door for a drop in oil prices as long as global LEIs erode, despite constructive underlying fundamentals. Furthermore, oil prices are well above their 2010 lows and stale speculative longs indicate the potential for margin-squeeze related pressure. However, I think it would take a prolonged US recession and/or Chinese hard landing to get a sustained drop in oil prices towards the USD70 and USD80 support zone for WTI and Brent, respectively.

Appendix: A more aggressive haircut for Greece

Although it is obvious that the second Greek bailout package needs to be renegotiated, there is a huge difference of opinion about what should be done. The usual suspects are lining up on each side of the debate: the Germans and Dutch want a more aggressive haircut, which the French and the ECB are resisting. A more aggressive haircut is needed for two reasons: first, to limit further official support beyond the

Good night, my dear friends!