June 24, 2011: Market Update

Can Icarus Fly Again?

The market looks to finish the week only slightly lower than where it started.  For an unusually volatile week filled with market moving stories, this is a reasonably good outcome.  The three big events that occurred this week were the vote of confidence for Greece’s Prime Minister, the Federal Open Market Committee (FOMC) meeting minutes and the surprise plan by the International Energy Agency (IEA), of which the United States is a founding member, to release additional oil from strategic reserves.

Following days of anxiety due to concerns over a possible Greek default, investors have been calmed for the time being by the confidence vote early Wednesday in Greek Prime Minister George Papandreou’s government.  Investors are hoping this paves the way to the passage of another batch of austerity measures in a vote next Tuesday. Greece’s partners in Europe and the IMF have made the $17 billion bailout (#2) contingent on a positive Parliamentary vote on the austerity package.

So why is Greece important?  The Washington Post laid out a very plausible scenario describing how a Greek default could ripple across the financial world.  According to them, this is how the dominoes might fall:

• Without an emergency loan from the IMF and European countries, Greece may default on $18 billion in debt it owes between July 15 and August 20.
• Greek banks hold nearly $200 billion of Greek debt, and a default could cause a collapse of the Greek banking system.  Germany, France and Britain own another $265 billion and would suffer significant losses as well.
• Because of the Federal Reserve’s zero-interest rate policy, many U.S. money market funds lend money to European banks at favorable rates.  The top ten U.S. money market funds collectively have approximately $380 billion in short-term investments with European Banks.  If European banks suddenly suffer huge losses due to Greece, U.S. money market funds would shy away from Europe and cause a liquidity crisis much like what happened in the days following the collapse of Lehman Brothers in the United States.
• Lastly, remember AIG?  They sold insurance called “credit default swaps” on debt holdings.  They went bankrupt when they couldn’t pay out on the claims.  There are over $5 billion in credit default swaps on Greek debt.  However, since the industry remains unregulated no one knows who holds the contracts or what impact a default might have on their financial health.

The Federal Reserve, the International Monetary Fund and the European Union are all acutely aware of the potential ramifications.  Because of recent history, we are confident that Greece will not be allowed to default (at least not in the near term).   The stakes are too high.

In other news, the Federal Reserve released the minutes from their latest meeting.  It turns out the economy is weaker than they had anticipated with Chairman Bernanke admitting, “We don’t have a precise read on why this slower pace of growth is persisting.”  The minutes of the FOMC meeting assigned blame outside of the U.S., pointing at Japan along with rising food and oil prices.  With the end of QE 2 next week, we anticipate the Fed will stay on the sidelines for the next couple of months while determining the size and scope of the current slowdown.  The earliest we might hear new policy coming from the Fed would be at the Jackson Hole Summit in late August (the event during which QE 2 was announced last year).

For the story of the week we turn to the U.S. Postal Service (USPS).  On the same day that FedEx announced a 33% jump in profits, the USPS declared an emergency end to its contributions to the federal pension fund for its workers.  This move by USPS, effective today, will save it $800 million by the end of the fiscal year on September 30.  The Postal Service reported a loss of $8.5 billion in its 2010 fiscal year.  It also reported a widening second-quarter loss, to $2.6 billion, on declining volumes.  Here’s the part you probably didn’t hear.  The Postal Service claims they overpaid the employee retirement account by some $6.9 billion and has asked Congress to pass legislation to return the money.  With several bills in Congress, it is unclear what potential remedies lie ahead.  “Right now we don’t believe this decision will have any impact on current employees and it will not have any impact on current retirees” said the USPS this week.  The real question is what impact this will have on taxpayers in the years ahead.  Now you know.

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