The financial markets are reacting negatively to three dangerous games of chicken being simultaneously played out across the globe.
In China, the new leadership team is waiting to see if the economy and stock market will stabilize before acting aggressively with stimulus. The IMF is waiting to see if the Greek government can use E10bln to buy E30bln face value of Greek bonds before they payout their portion of the new bailout funds. Finally, President Obama is waiting to see if Democrats can convince Republicans to raise taxes and the debt ceiling without changing entitlement spending.
For China, the recent spate of economic data has been improving slightly and appears to be providing some confidence in currencies that are linked to the country's domestic activity. As an example, the Australian dollar is typically a currency that waxes and wanes with China. Despite the 5.1% drop in the U.S. S&P from November 6th to the 15th, the AUD only fell from 1.0435 to 1.0288. The problem for China is that the domestic stock market has no responded to the improved economic data and has continued to fall.
Over the same November time frame, the Shanghai Composite stock index has dropped from 2,114 to 2,104 — and then continued to drop with a new low today at 1,973. Regulatory data showed the number of stock trading accounts that made transactions last week was the lowest since at least January of 2008 according to Bloomberg. It appears that domestic Chinese investors are voting with their feet on what is happening with the economy.
(Read More: China Stocks Slump, but Don't Expect Beijing to Help)
For Europe, the announcement on Tuesday of a deal for Greece to receive E34bln had an immediate positive reaction with the EUR briefly rallying above 1.3000 on the news . Yet, the currency fell the rest of the trading day and created the technical sell condition of an outside reversal (higher high, lower close from previous day=sell signal).
This selling persisted into today as the details of the Greek bailout deal are less than desirable. One of the key components of the deal centers on the willingness of the IMF to support the funding. In turn, the IMF is conditioning their support to the ability of the Greek government to execute a buyback of Greek debt from bondholders at a price 25% to 30% of the face value of the bonds. The outline is to use E10bln of funding to buyback E30bln of bonds. While the Greek government may get domestic bondholders to go along with the deal, foreign investors are incented to hold out for a higher percentage similar to how other holdouts that declined this year's restructuring got paid in full. For the markets, they are voting with their feet as well given how tenuous the IMF support is for the deal.
(Read More: Revisiting the Point of the Euro)
For the United States, the negotiations on the fiscal cliff are entering into a critical time frame.
The markets rallied significantly last week as they had a sanguine view that no news was good news on the discussions in Washington. They were rudely shaken out of that mindset yesterday when US Senate Majority leader Harry Reid stated that he was disappointed over the pace of the negotiations and stated there had been little progress made resolving the fiscal cliff of tax increases and spending cuts. Moreover, he went on to say that President Obama and he are in agreement that Social Security should not be part of the deal and that the deal should include a debt ceiling hike.
This encapsulates the great divide between the parties on how to proceed. The Democrats believe that by winning the presidential election and adding to their majority in the Senate that they are empowered to raise taxes and cuts deductions on the top two brackets while leaving entitlement programs untouched. By retaining their majority in the U.S. House of Representatives, the Republicans believe they are empowered to pass all of the sun setting tax provisions and then have a larger deal on cutting spending, reducing entitlements and fixing the tax code to promote growth. For the markets, they are pricing in the risk of an impasse in the talks that leads to either a weak deal or no deal at all.
Before and after the election, I warned of the potential for this path on the U.S. fiscal cliff talks. I was surprised at last week's strong rally back in U.S. stocks and the subsequent drop in the U.S. dollar. Yet, this week we have now three "chicken" scenarios instead of one. This ups the potential for a collision. Unlike the participants in the "chicken" game, traders and investors won't sit idly by hoping a collision is avoided. I expect the markets will continue to reduce risk into December.
Andrew B. Busch Director, Global Currency and Public Policy Strategist at BMO Capital Markets, a recognized expert on the world financial markets and how these markets are impacted by political events, and a frequent CNBC contributor. You can comment on his piece and reach him here and you can follow him on Twitter at http://twitter.com/abusch .