Market Perspective for June 12, 2015

“How did you go bankrupt?”
Two ways. Gradually, then suddenly.”
— Ernest Hemingway, The Sun Also Rises

While Greece will likely dominate the news cycle if it ends up defaulting on its debts, the more important news this week is the strong pickup in economic activity and signs of rising inflation.

Greece is suddenly facing default after debt negotiations broke down over the past few days. Yesterday, the IMF quit negotiations and went home due to the lack of progress. Today, Macedonia barred Greek banks from borrowing money to protect Macedonian banks in case Greece exits the euro. Although Macedonia is not going to force Greece out of the euro, this is exactly what banks did to Lehman Brothers ahead of its collapse. Once banks refuse to do business with an institution because they fear insolvency, the institution is effectively insolvent.  If other countries follow Macedonia, or banks individually refuse to do business with Greek banks, then the Greek financial system is effectively out of business.

Germany is reportedly considering capital controls and a debt write off for Greece, which ultimately is the best outcome for the country because it cannot hope to repay the debt it has, let alone the additional debt any further bailouts would add on. For the moment, the currency market is either not believing Greece could default or the currency market doesn’t care about Greece, because the euro is holding steady. Greek equities have been falling on the news, though as of Friday morning, shares were still up for the week.

Domestic stocks are being pulled lower on Friday due to Greece. The S&P 500 Index came into Friday with a 0.76 percent gain for the week but shares were off  more than 0.5 percent in early trading.  The Nasdaq was flat for the week as was the Dow Jones Industrial Average. The Russell 2000 remains the bright spot: it is up for the week and only down slightly in early Friday trading. Small-caps have been doing well for several weeks now, and that is a bullish sign for the overall market.

The bond market may be poised for even more volatility over the coming days. The repo rate on 10-year treasuries fell to negative 2.2 percent on Friday. At 2.2 percent, this implies the market is very short of collateral and the simplest explanation is that a lot of money is betting on bond prices falling. It also makes sense given the economic data that has come out.

On the positive side, economic data has taken a sharp turn for the better. Retail sales were up 1.2 percent in May and revised higher for March and April. Wholesale inventories climbed 0.4 percent in April. The Atlanta Federal Reserve hiked its GDP Now forecast from 1.1 percent up to 1.9 percent based on the improving data.

While this improvement will push the Federal Reserve closer to raising rates, potentially more important number out this week was first quarter employer compensation costs, which jumped 4.9 percent. Nearly all of that increase was due to healthcare, but whether an employee is paid the wage or not, the rise in compensation costs is inflationary. This jump in costs reflects the CPI data from April, which showed medical costs as a growing source of core inflation. Producer price inflation for May, released today, also points to increasing inflation. It all may be a short-term blip in the data, but if not, core inflation will quickly move into the Federal Reserve’s target range.

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