On the day when Greek 1Y yields broke above 400% for the first time, a consideration of just what Greece would look like post-exit is perhaps fruitful. Looking at hypothetical forward rates (generated from covered interest rate parity between EURUSD FX and EMU sovereign interest rates), MSCI has an interesting analysis [3] of what a decoupled Drachma (and for that matter Lira, Escudo, and Irish Pound) would look like. Given the Greeks entered the EMU in January 2001 at 340.75 Drachma to the Euro, the current market is pricing in a massive devaluation to around 1530 Drachma to the Euro. Perhaps as further evidence of the market's perspective that a devaluation is likely, from extremely high correlations just over a year ago, the implied new Greek Drachma vs Euro has dropped to almost negligible correlation against an implicit Deutschmark vs Euro. As the PSI discussions go from bad to worse (as we expected and discussed yesterday [4]), it seems the market is increasingly expecting at best a coercive agreement (if not outright exit).
[5]
The implied forward exchange rates (inferred from interest rate parity differentials) across the various peripheral European nations (as of mid December). This is the devaluation against the Euro so a ~4.5:1 devaluation as is evidently priced into Greek curves implies the 340.75 Drachma to Euro rate will devalue to around 1530 Drachma to the Euro. The Portuguese are obviously better but face significant devaluations also.
[6]
And the decreasing correlation between an implied Drachma and Deutschmark suggest the market is increasingly expecting this exit or devaluation to happen. This is evident when one notes that even 1Y GGBs are now breaking to record yield levels - over 400% for the first time today:
[7]
Source: MSCI [3]