The Wall Street Journal's Heard On The Street points out the apparent contradiction between all the, so far, empty rhetoric involving Greece, and the bond market's relentless ignoring of all things favorable. Images of Lehman's stock trajectory in July and August come to mind.
The latest jump in Greek government bond yields raises a worrying possibility: the government bond market is starting to malfunction. The moves in Greek yields are occurring on relatively low volumes, with individual trades around one-third the usual size, traders say. The selling pressure seems to be being driven more by some institutions' inability to hold volatile assets than new concerns about Greece's budget problems. But the volatility also is preventing buyers from snapping up the paper, even though many agree Greek yields are attractive and officials across the euro-zone dismiss talk of a Greek default as irrational. Meanwhile, market psychology now seems to interpret all news about Greece as negative.
The implication is that coupled with the newly emerging austerity measures in Portugal, Europe, but mostly Germany, will run out of options very quickly. On one hand Trichet and Merkel have stuck themselves in a corner with all the recent anti-moral hazard talk (and the question of whether Europe's strapped public sources can accumulate enough bailout capital in time is still open), and on the other, as Lehman so well demonstrated, a colossal event such as a eurozone member defaulting, would likely have the exact same unpredictable domino consequences that everyone has long been warning about. The silver lining - an imminent drop in the euro, and a boost to European exports. Perhaps this is the agenda all along - Greece will be the sacrificial lamb which will satisfy the bloodthirst of French and German unions, and prevent political landslides in all of Western Europe. And the kicker - they can't tell Bernanke and the U.S. they did not go along with the G-20 plan of keeping the euro artificially high: after all this will be spun as an "exogenous" event.
And the good thing is, everyone still has a very fresh memory of what happens when the liquidity premium is added to the equation.
There are echoes here of previous disruptions in credit markets, including the breakdown in the covered bond market in the fall of 2007. Then, spreads on high-quality bonds that were highly unlikely to default widened sharply even on small sales, as risk-averse banks found themselves unable or unwilling to take the risk of market volatility. That this now appears to be occurring in the government bond markets suggests the financial system is still extremely fragile— a concern when central bankers are talking about the need to start removing the extraordinary liquidity support they have provided.
Yes, the implications of a default are bad, but unlike the U.S., Europe seems willing to take the pain and rebuild later, the diametrical opposite of what America has done. And with a euro crash, the key variable toward rebuilding the European economy will be in place.
The bigger problem is that even if Greece does take the fall, how far behind can other countries be?
The lesson from the financial crisis is that when liquidity evaporates from a market, stronger sovereigns need to step up and backstop the system. Greece's woes may not and, arguably, should not reach that point. But if the volatility continues, other states facing budget questions, like Portugal and Spain, could find themselves in the firing line.
Ironically, the bitter medicine for the rescue of both Spain, Portugal and the other PIIGS may just the transformation of PIIGS to PIIS.
Either way, the next two weeks will be critical in deciding Greece's future.