Greece’s historic referendum is in the books and confusion now reigns in Europe and in stock and bond markets across the globe. Put simply, no one — not the politicians, not the analysts, not the traders — has any idea what happens next because there simply is no precedent for a voter-supported exit from the EMU.
While markets, as a rule, hate uncertainty, the environment on Monday is more than uncertain. This is a case of outright confusion and until there’s at least some degree of clarity on whether i) debt restructuring will form the backbone of a renegotiated deal between Athens and Brussels, and ii) whether the ECB intends to allow Greek banks to reopen this week, the “market” (so that’s the algos and whatever carbon-based lifeforms are still crawling around out there) can’t even begin to decide which uncertain future it should fear. Is near-term contagion risk triggered by a Greek banking sector meltdown the problem or is the real issue that a negotiated restructuring of Greece’s debt will alleviate the short-term crisis but make it more likely that the entire drama will repeat itself with Spain and Portugal? No one knows and so at least for the next 48 hours, the only thing to fear, so to speak, is fear itself.
Once the market has a better idea about whether it should fear a near-term, Lehman-style meltdown or a longer-term reimagining of the entire European project, periphery spreads (not to mention EU equities) will begin to price in the uncertainty and at that point the ECB’s contagion fighting “tools” (outlined here earlier today) will be put to the test. Citi has more on the above and on the “trigger” point for ECB intervention.
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Big picture thoughts
The myopic focus on contagion here should not hide the long term implications of events now unfolding, with one negative for periphery being that Greece has already set a bad precedent (as far periphery bonds are concerned) where reform/austerity is put directly to a plebiscite.
If Greece comes to the table and agrees on a new bailout avoiding default and Grexit, the implications are that the Euro region is indeed robust, but that will only be evident many months into any new bailout.
Default inside the Euro area by Greece, but no Grexit, is not positive for periphery risk primarily because forces from the political extremes would see this as somehow favorable, despite the economic pain. That is, it is not just Grexit, that delivers risk of political contagion.
Finally, if Greece does exit the Euro, investors will have learned that markets cannot break the Euro but democracy can. That adds risk premium for periphery medium term given that (a) the absence of large contagion limits the motivations for a political integration response and (b) because a debt overhang with political fatigue in Europe, will not necessarily be a unique Greek experience in the next recession.
Next steps – and watching the 20th July bond redemption
Euro area leaders have called Summit for Tuesday ahead of which a Eurogroup meeting will take place. We do not expect significant concessions on debt haircuts or the conditionality of the programme. That means, with Greek banks likely to face closure, markets will focus on whether the 20th July €3.5bn bond redemption to the ECB is a default event.
How do bonds trade?
The most important feature of the periphery trade around the Greek crisis is the relative calm in how markets have traded. This is related to two factors. Firstly, Greece looks more of an exception than a template in respect of both politics and economics. Secondly, the ECB is signaling that it is ready to provide a firewall. For instance, the statement last weekend, noted that
“The Governing Council is closely monitoring the situation in financial markets and the potential implications for the monetary policy stance and for the balance of risks to price stability in the euro area. The Governing Council is determined to use all the instruments available within its mandate”.
Benoit Cœuré then repeated this message and noted the latest ruling by the European Court of Justice highlighted the “need for the ECB to have some room for manoeuvre” in the choice of its instruments in order to fulfil its mandate.
He followed this up this weekend, by saying the ECB is ready to take additional measures to support the eurozone at a "time of uncertainty". He added that "In the current circumstances of great uncertainty in Europe and the world, the ECB has been clear that if we need to do more we will do more. Our will to act in this matter should not be doubted".
That sounds very much like ‘whatever it takes’ remark and in this respect we have little doubt that the ECB will act either through more QE (if economic sentiment is hurt) or perhaps through more targeted purchases of periphery paper.
It is not known whether any periphery specific purchases will be centralized risk or via the balance sheets of the NCBs – but for now we doubt this matters because we do not think the ECB will fail to make its mark if it decided to act.
The common view of the ECB is that they are slow and meek. The slowness to respond to disinflation is correct but when the ECB acts it can typically surprise in its size and aggression – as with QE itself.
We would begin to doubt the ECB firewall only if the ECB interventions were any combination of collateral moves or OMT, where the latter would be seen as a policy error given the need for MOUs to activate. That would add a new political crisis and is probably why the ECB is signaling that it is looking at its monetary policy stance – a string hint that asset purchase is on the radar.
Periphery levels: 3% in 10y BTP to price ECB intervention risk
As we wrote recently, our central view is that periphery contagion is limited by the ECB signaling effect, but should markets fret, and ECB action becomes necessary then we think the markets will price ECB action well before highly stressed levels.
If we for instance take it view of the monetary policy stance impact seriously then market moves that take real yields to levels that persisted before the ECB started easing policy (negative rates started in Jun 2014) may be a trigger point.
Markets would anticipate ECB action on a move of near 50bp in real 10y BTP yields and this is consistent with 10y nominal BTP nearer 3%.
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Note that Citi has effectively ruled out two of the ECB's contagion fighting tools as not credible. Anything that requires an MOU or isn't conducive to unilateral activation and implementation will make the market "doubt the firewall." In other words: it's more QE or nothing, and at least according to Citi, the threshold is pre-June 2014 Italian spreads.
At that point — i.e. at the point when Goldman's conspiract theory stunner finally comes true and PSPP is expaned in order to "fight contagion" — the only remaining question will be how long it takes for ECB purchases to suck so much liquidity from the market that all non-central bank buyers begin to demand higher yields to compenstate them for the liquidity risk. When that happens, the ECB will officially join the Riksbank in what will be an ever growing pool of central banks who, having reached the monetezation endgame, will either admit defeat or go to Defcon 1, the monetary paradrop.