As forecasts for peripheral macro data continue to deteriorate and core to strengthen modestly, there is little real comfort available from the European situation aside from the 800lb gorilla that all headlines are focused on today. Credit Suisse describes it as "a case of the outlook being less bad than expected, rather that it being better" and notes that post the Greek situation, despite the ongoing rally in the ever-thinning sovereign bond market, that risk premia (that were dangerously forgotten for the first decade of the Euro) will remain at elevated levels. CS sees three scenarios beyond Greece with even the best-case leaving questions of sustainability, trust, and continued negotiations yet the market's willingness to follow along the path of inevitably ruinous policies seems writ large with today's credit, equity, and FX strength.
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Economic growth forecasts revision - core up and periphery down
Looking beyond Greece we think the key factor driving spreads and yields will be the growth prospects of European countries. In the pre-crisis days low growth implied low yields. This may continue to be the case for core markets, but for non-core markets a lack of growth means that the debt burden, and hence the risk premium, will remain high. In pre euro days we see a positive correlation between yield levels and growth. This is less evident post euro and the most recent development is that yields have been rising as the growth outlook has been declining.
We think this marks a significant change in market perception of sovereign risk. For the first ten years of the euro the market has effectively priced out the risk premium for European sovereigns. On the basis that Greece is resolved in a relatively orderly fashion, we think markets will continue to price in this risk premium, and although peripheral spreads may experience some tightening versus core, we think the risk premium remains at elevated levels.
(Trying to) look beyond Greece
As we monitor developments, and look to evaluate the outlook for the European government debt markets post the 20 March, we therefore see broadly three general scenarios:
- Debt restructuring completed in (relatively) orderly manner and vast maturity of Greek debt has been restructured, second bailout in place.
- Partial restructuring with ongoing debate – continuation of current situation.
- Failure-to-pay or debt moratorium on 20 March bond.
As we proceed towards a solution, we expect the market to remain volatile and the periphery to sell off; the longer we go without a clear proposal and timetable for implementation, the greater the probability of an “accident” and therefore the greater the likely risk-off moves.
Once the details have been released, if the debt exchange appears to be proceeding as intended, with a high probability of the first scenario being achieved, then we believe the periphery will outperform and bunds will sell off; near-term volatility could provide a good entry point for these positions.
Despite a deep debt restructuring, Greece would be likely to continue to provide headlines – the severity of the austerity measures and the dire state of its economy mean it will need support from the euro area for the long term in order to regain competitiveness, and this route is unlikely to be smooth or popular with electorates inside and outside Greece. Once the vast majority of private debt has been restructured and termed out, it is possible that the situation in Greece has little ongoing impact on the broader markets, with sentiment driven by developments at the other sovereigns, and likely in the banking sector. This, we believe, is a plausible scenario for post-restructuring Europe provided that the political situation in Greece remains relatively stable and the long-term commitment of the euro area to Greece is in no doubt. A continuation, or escalation, of the discussion of Greece being better off outside the euro area would be extremely negative in our opinion, leading to further volatility and contagion and is a substantial risk.
Scenario two is more of the same as we’ve had recently, with the associated negative implications for market sentiment. The periphery would likely sell off further, with the potential of increased contagion towards the core, as there would likely be increased scepticism of the ability of policymakers to reach an agreement and increased talk of Greece leaving the euro.
Scenario three as we have said above would be catastrophic, in our view – Greece would almost certainly need to leave the euro, and contagion would continue into the core of Europe in time. In the absence of substantial additional policy intervention, we would expect an immediate and substantial widening in peripheral spreads. The initial move in German yields would likely be a rally, but we don’t believe this would be sustainable, as the risk premium required in German bonds would need to increase significantly. The time frame for moves would be a function of other measures put in place in order to stem the contagion.