Committee for a Responsible Federal Budget

Market Watch: More Spillover from Greece

May 21, 2010 | Economics

Throughout the week, U.S. financial markets continued to be dominated by a global market “flight to quality” in response to perceived EU policy weakness in addressing the Greek and eurozone fiscal crisis.

Already alarmed by the inability of EU leaders to quickly move ahead to put the Greek rescue package in place and to strengthen the EU fiscal framework, markets became even more unnerved when Germany restricted short selling of certain “uncovered” financial instruments out of the blue (ie, selling instruments that are not owned or borrowed). While some policy surprises can have a positive effect, the German move had the opposite effect, by ratcheting up market fears that EU leaders were focusing on punitive solutions that would change the rules of the game without notice, rather than on addressing the basics of their fiscal crisis – the weak EU fiscal framework.

(While financial market reforms can and should be debated – and must be adopted to prevent another financial market crisis – a policy surprise can be destabilizing for reasons that are easy to understand. An abrupt change can be costly to traders, who have staked out certain positions based on the rules in place. With financial sector reforms moving ahead in the U.S. now as well – the Senate just passed a comprehensive financial reform bill – market uncertainty about the U.S. market might increase until a final bill is agreed on in the House.)

As a consequence of this week’s near-panic, investors moved into instruments perceived as safe havens, including U.S. Treasury instruments. Yields on the benchmark 10 year note fell to their lowest point since December.

News from Europe fed into the week’s snapshot of economic weakness, and jolted our stock market. U.S. economic news of the week gave rise to a narrative of a weaker upswing than assumed by many (including our stock market bulls) and suggested that the risks of deflation might be higher than most expected. Consistent with the U.S. domestic news narrative, needed EU austerity plans will slow European growth and thereby dampen U.S. export growth; the stronger dollar (as investors shifted from the euro) is also seen as slowing U.S. exports. The Administration is counting on strong export growth to help improve employment.

As of mid-day today (Friday), looking ahead to next week and beyond, there is a change in market drivers. EU leaders are taking a series of steps that could calm down markets by removing policy uncertainty and signaling that they are taking serious steps to strengthen the EU fiscal framework. The turning point may well be the German Parliament’s decision today to (finally) support the Greek rescue package. And EU leaders are scheduled to meet to discuss proposals by the European Commission to strengthen the eurozone’s fiscal framework.