Even as the probability of a Greek exit from the euro approaches even money, credit markets have, like the children of Hamelin, been hypnotized by the sweet sound of the ECB’s printing press which Pied Piper Draghi has promised to keep humming until at least a trillion new euros have been minted. So far, the overwhelming temptation to front-run this latest tsunami of CB liquidity has driven euro IG spreads to record lows (with IG cash significantly outperforming CDS during last week’s turmoil) which, in turn, has herded investors into higher yielding credit (Xover/Main spread ratio at its lowest level in months).
Even if the ECB’s decision to join the global QE cabal is enough to keep a lid on things outside of GGBs and the hemorrhaging Greek banking sector, promises of debt monetization will be utterly insufficient to allay the market’s fears if the Syriza “virus” does indeed spread beyond the Aegean to larger, more consequential member nations. Of course, this has already happened in Spain where Podemos and its leader Pablo Iglesias have pledged to restructure some $1.1 trillion in Spanish debt. Needless to say, this isn’t the type of rhetoric the sovereign debt market likes to hear and analysts are already speculating on how far yields will rise in the event Podemos’ popularity persists.
From Bloomberg:
Pablo Iglesias’s pledge to restructure $1.1 trillion of Spain’s debt could make investors more cautious about the nation’s bonds, a survey showed.
The rising popularity of Iglesias’s anti-austerity Podemos party could mean Spain pays an extra 50 basis points on securities maturing in ten years, according to the median estimate of nine economists surveyed by Bloomberg News.
“In case of a Podemos clear victory, the 10-year-spread between bonos and bund may increase as much as 50 basis points,” said Jean-Louis Mourier, an economist at Aurel BGC in Paris, referring to Spanish and German securities. “If a debate emerges about a possible repudiation of part of the Spanish debt, tensions would be more intense on the short or medium part of the yield curve.”
This may be understating the case. Whereas Greece accounts for a mere 2% of eurozone GDP, Spain clocks in at around 11%, and as we saw in the summer of 2012, once yields on Spanish 10s start approaching the point of no return (i.e. 7%), all bets are officially off.
The critical point though, is that a deterioration in the market for Spanish sovereign debt would likely have a severe and immediate knock-on effect. Why? Because IG credit tends to track the big peripherals (especially Spain), not Greece.
From Barclays:
The other channel for contagion, and in our view the more systemically important one for credit markets as a whole, would be the return of re-denomination risk. Specifically, if markets start pricing an increased risk that other member states would exit the currency union (which seems likely, at least to some degree), then the risks … may no longer be ‘contained’. Corporate and bank exposures to Spain, Italy and the other European economies are clearly much more material. Throughout the euro area crisis, credit spreads were more closely correlated to the performance of Spain and Italy than to Greece and we expect this to continue.
Indeed, the correlation between euro IG credit and Spanish yields shows just how important the political situation in Spain truly is:
And although ECB front-running has kept Spanish and Italian spreads compressed…
...the contagion risk is very real.
Here’s Barclays again:
...politics could be a transmission channel and countries such as Spain could suffer from contagion despite its robust economic recovery, unless support for (Syriza-like) Podemos diminishes in the face of Greek hardship in the aftermath of an exit.
The icing on the cake: CDS spreads for Spain and Italy are trading far tighter than they should be even if we assume no Grexit!
It turns out that the next best thing to Greek contagion in this bizarro, centrally-planned world is... anti-contagion.
