Earlier this week, the largest Swiss bank UBS, not only suggested to anyone following the latest Greek crisis that "now may be a time to panic" (not in so many words) when it laid out its latest asset reallocation, slashing its equity exposure...
... and explaining that the stock market is far too nonchalant about the risk of a Greek contagion, which as it also showed, would spread like wildfire if push comes to shoving Greece right out of the Eurozone.
And just to be extra useful, UBS also summarized the process of the Grexit in the following handy flowchart:
But why are markets so nonchalant about the risk of a Grexit? Here is Goldman wiuth its explanation for why there has been none of the typical drama that accompanied either the first Greek crisis-bailout in 2010, or the second one, from 2012. The basis of Goldman's thesis: Q€ of course.
From Goldman, first, the good news:
EMU Peripheral Yields Have Decoupled from Greece in Levels ...
Greek sovereign bond yields have been going up since last September and, since January, the term structure has become inverted. Explaining the divergence with the rest of EMU have been a number of factors including: the approaching end of the ‘troika’ funding program; increasing popular protests against austerity measures; and growing political pressure on the centre-right coalition government, culminating in the election of more radical parties.
Meanwhile, sovereign yields in Italy and Portugal – the two Euro area countries with the highest public debt-to-GDP ratio after Greece – have continued to decline in the wake of their German counterparts, responding to the ECB’s increasing monetary expansion and, progressively, the anticipation of sovereign QE. The spreads of Italian and Portuguese bonds to Germany are now at levels seen in 2010, and overall funding levels are substantially lower.
... But Their Correlation to Shifts in Greek Risk Remain Positive
A closer empirical analysis (using a dynamic conditional correlation approach) based on data spanning the beginning of 2012 to today reveals that:
- In Greece, the daily volatility of intermediate maturity bonds is now back at levels seen in the first half of 2012 (even though yields are lower), while that of intermediate Italian and Portuguese yields is around half of where it was in the first half of 2012.
- The correlation between Greek and German yields has been negative on average throughout the past two years, as Greek credit risk has remained elevated while risk-free rates have rallied. By contrast, the co-movement of daily changes in Italian and German yields has moved from negative (-40%) in 2012 to slightly positive currently (+20%). The same holds for Portuguese yields.
- The daily correlation between government bond yields in Greece and those of Italy/Portugal has been stable at positive levels over the entire period in question (40% for Italy and around 50% for Portugal) since 2012.
Summarizing this evidence, the credit risk embedded in Italian and Portuguese government bonds has gradually diminished, a development reinforced by the inclusion of these countries in the ECB’s purchase program. Returns on these securities are now mostly influenced by shifts in risk-free rates. Both sovereigns, however, remain exposed to fluctuations in Greek credit risk.
Then some more good news:
Why Is Contagion from Greece Contained?
So far we have described through statistics the behaviour of asset prices. As to the economic rationale behind a departure between Greece and the rest of the EMU periphery, we would note that:
- The new Greek government has been elected on a policy agenda set to relax the fiscal stance and further restructure public debt, but not to take the country out of EMU. The central scenario of most of our clients (and ours) is one in which a compromise with Greece’s official sector creditors will ultimately be found.
- Since the overwhelming majority of Greece’s public debt is either in the form of loans from the EFSF, the IMF or other EMU countries, the international private sector exposure to Greece is limited. The EUR40bn worth (at face value) of Greek government bonds traded in the secondary markets is generally marked-to-market. The activation of the ECB’s emergency liquidity facility has channeled more funding to the Greek banks from the official sector, reducing direct private exposures further.
- The ECB’s sovereign QE, to start next month, is estimated to remove as much as 50% of the gross issuance of sovereign bonds in the likes of Italy, Spain and Portugal. This will reduce debt roll-over risk, which should translate into an even lower probability of default in coming years.
Based on these considerations, it looks reasonable that investors would not ask for an additional compensation for a source of risk that has limited direct economic bearing for other asset classes.
And now the bad news, and when the above idyllic scenario would promptly collapse:
Such a conclusion would cease to hold, in our view, if Greece were to leave the common currency. Indeed, ‘Grexit’ would constitute a non-diversifiable event, affecting all financial assets. This is because, upon the departure of one of its members, EMU would likely be seen as a fixed exchange rate arrangement between countries which can elect to adhere or leave. Convertibility risk would resurface, exposing the possibility of a collapse of the entire project.
To be sure, the ECB would not stand idle in the face of such a course of events. But the severity and persistence of the ‘shock’ from Grexit would depend on several factors, which include:
- What has led to the departure of Greece (metaphorically, was the country pushed or did it jump?).
- What institutional arrangements the remaining countries put in place to signal their commitment to stay together (presumably in the form of greater sovereignty sharing).
- How does Greece perform outside of the single currency?
So what Goldman is saying is that with its intervention in all markets, the ECB has made discounting of risk virtually impossible. In fact, unlike on previous occasions when the market at least swooned ahead of the Grexit D-Day (and flash crashed in May 2010 when scenes of rioting in Athens led to a cascading HFT sell program) it may have prevented the Grexit itself by giving a glimpse of the devastation that would ensue if the Eurozone were to fall apart - which by now is clear to all is merely a political entity, preserving "political capital" - this time it is the central banks' pervasive domination of all risk levels across the board, that has made negotiation a non-starter, since Europe is essentially convinced it can let Greece go. After all, just look at the DAX at all time highs - surely the ECB has everything under control.
Everything, that is, unless Greece exits, when as even the former employer of the ECB's Mario Draghi admits, it would be time to panic.