Morgan Stanley On What Happens Next In Greece, And Why It Is All Very Euro Negative

From Morgan Stanley on why anyone betting on a quick rebound in the EURXXX will be sorely disappointed.

Euro And The Greek Confidence Vote

The EUR is set to remain under pressure as the uncertainty regarding Greece intensifies once again. Any comfort for the EUR from reports Merkel and Sarkozy are to meet with the Greek government and IMF officials Wednesday, ahead of the G20, is likely to be short-lived in our view.

Indeed, Friday’s confidence vote in the Greek parliament will be extremely important in our view and will likely set the pace of the anticipated EUR decline over the coming months. Greek Prime Minister Papandreou could now find it difficult to win a confidence vote (due Friday 10GMT) given the defections from the government leave only the slimmest of majorities (just 151 votes in the 300 parliament).

If the Greek PM fails to win the confidence vote then the government will fall. There is the possibility for a new Government under a different PM or the formation of a unity government. But these outcomes seem unlikely given that the opposition is strongly in favour of new elections. While new elections will delay the vote on the new budget reform measures and potentially delay the next round of bailout funds from the EU, this is likely to be seen as one of the most positive (least bearish) outcomes for the EUR as it will avoid a referendum. There could even be an initial relief rebound for the EUR on any news that a referendum is being avoided, by the continued uncertainty and delays with regard the passing of the new budget measures and payment of EU bailout funds will likely keep the EUR under pressure over the medium term.

Indeed, most of the options under discussion in the market are EUR negative in our view. A victory by Papandreou in the confidence vote on Friday is likely to be seen as the most bearish for the EUR, opening the door to a referendum and the potential rejection of the bailout package by the Greek population. A referendum is likely to be difficult to win given that the opinion polls show that most of the population are opposed to the latest austerity measures. Hence, we would anticipate a continued sharp EUR decline if the Greek government passes the confidence vote Friday.

The delays and uncertainty leading up to a referendum are likely to provide a negative environment for the EUR as well as for broader risk sentiment. Indeed, this has the potential to trigger significant tail risks, including making it difficult to attract investors for EFSF bonds - EFSF funding is likely to have to start in earnest in November. The ECB may have to extend its asset purchase programme to absorb bonds the EFSF will not be ready to buy. The ECB's balance sheet could extent further as a result, putting the EUR under broad pressure.

But we suggest that the Greek government would get the help of the EU in persuading the population to vote in favour of the referendum. However, while any sweetening of the deal will also raise concerns regarding moral hazard, the EU will be extremely anxious to avoid the negative fallout that is likely to be generated by a failed referendum.

The sharp decline of EURUSD over the past couple of days has already breached important support levels suggesting a decline towards 1.3365 and then the 1.3145 low seen early October. We maintain our 1.30 year-end forecast for EURUSD, with 1.25 targeted in Q1 2012.


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