“A default is not an issue for Greece,” Jean-Claude Trichet, head of the European Central Bank, told a press conference in Frankfurt today, April 8.
The bond market begs to differ. Greek bonds sold off today bringing the yield premium to benchmark German bonds to 4.27 percentage points. That’s the biggest spread since the start of the euro. The average spread over the last decade has been 0.34 percentage points.
To be fair to Trichet, the difference of opinion could simply be one of timing. Greece does not face a default this week or month. If that’s Trichet’s time frame, then he’s correct. But the bond market is looking somewhat further out and what it sees is a process that finally, sometime in 2011 in all likelihood, results in a Greek default.
The bond market’s logic is very simple. Greece is going to be forced to pay so much to fund its debt that the country simply won’t be able, at some point, to pay the price. Remember, the bond market is saying, that this is a country that’s being asked to cut government spending and private wages to a degree that will send the economy into a recession.
And it’s not like the economy of the rest of the European Union is growing so fast that it can pull Greece out of a recession. Revised numbers show that from the end of the third quarter to the end of the fourth quarter of 2009 the EU economy didn’t grow at all.
What does this mean for investors?
No quick end to the crisis but a steady drip, drip, drip of bad news and worry that’s likely to stretch into 2011.
Continued weakness in the euro as long as the crisis lasts.
Pressure on the debt and economies of other troubled euro economies such as Portugal and Spain.
And a continued drag on global economic growth.
The basic problem is that the basic problem with Greek debt hasn’t been fixed. The country has been able to refinance debt that has come due so far this spring but at interest rates now above 7%. The yield on the Greek 10-year bond stood at 7.31% when Trichet began his press conference.
But Greece needs to refinance $15.5 billion in debt by the end of May and another $27 billion by the end of 2010. That may not seem like much until you remember that Greece has an economy only about 1/42nd as large as that of the United States. Refinancing $42.5 billion in debt for Greece is equal to refinancing $1.8 trillion in debt for the United States.
I don’t think there’s any real doubt that Greece will be able to refinance its debt this year. But the cost is only likely to rise from today’s already staggering yields.
The risk of default will just by itself keep upward pressure on interest rates.
But new lending rules at the European Central Bank will hurt too. By old pre-financial crisis rules government bonds with the kind of low credit ratings that Greece now gets from two of the three major debt rating companies would have prevented banks from using their holdings of Greek government bonds as collateral to borrow from the European Central Bank. That would have made banks even more unwilling to hold Greek government debt—driving up yields—and it would have pushed Greek banks, which hold proportionately large amounts of Greek government debt, into crisis. They wouldn’t have able to borrow to fund their own operations—and they wouldn’t have been able to sell their holdings of government bonds without taking huge losses.
During the financial crisis, the European Central Bank suspended those collateral rules. But once the crisis was over the central bank started to talk about moving back to the old rules. That would have pushed Greece into financial chaos.
The good news is that the new rules will allow Greek—and other–banks to continue to use Greek government debt as collateral for borrowing from the European Central Bank. The bad news is that the new rules will make it expensive to do so.
The bank will now impose a haircut on low-rated debt used as collateral beginning on January 1, 2011. So, if the haircut is 5% to 10% as now seems likely, the central bank will accept a Greek government debt (or other low-rated bonds) for collateral at a rate of just 95 cents to 90 cents to the dollar (or euro, actually.)
Yes, the haircut rules don’t go into effect until 2011, but if you ran a bank would you be rushing to stock up on Greek debt knowing that in 2011 you will be able to borrow just 90% to 95% of its value?
Looking at all these dynamics, the bond market is saying that it doesn’t see any way out for Greece except an eventual default. Rising interest rates will slow the Greek economy—already suffering from budget and wage cuts—lowering government revenues, making larger budget and wage cuts necessary, which will slow the economy and lower government revenues even more. That in turn will make bond buyers even more reluctant to buy except at even higher yields.
Do you see something that the bond market is missing? I don’t.
mjcowan,
Just an FYI: The SEC is investigating a lot of the leveraged ETF’s, and might even shut down some, or all, of them. While this is not going to happen overnight, I certainly wouldn’t hold a double short ETF for an extended period of time, like until 2011.
Having said that, it could be a decent short term play. Be careful though. If they announce some kind of Greek rescue plan that looks legit, the euro might go up. Although that looks like a long shot possibility right now.
Jim,
With the problem in Greece and potential problems in other Euro economies wouldn’t it make sense buying DRR and holding into 2011?
viwi,
Thanks for sharing that! I do enjoy hearing other people’s strategies. That is a rather intriguing one.
elnormo: One of the possible starting points is Jim’s watch list. You watch those stocks closely and record how they react on a certain event. My watch list is actually three times longer, because I am willing to take a risk. In a particular case of Greece, I played LYG. I started buying it sometime in February at around 3.25 and averaged down to accumulate a total of about 30,000 stocks at around 3.00. Sold it all, when LYG briefly touched 4.00. 30k in about 1 month or 30% profit is not a bad thing. My general strategy is simple: I am looking for stocks with large beta. They tend to overreact on bad news. If you are “too big to fail”, there is a good chance that this company will be around a month later when the issue is resolved. LYG satisfies both parameters, and so far I am happy with it. But there are other options as well.
One thing I learned very quickly – you can’t follow somebody else advice when you are dealing with your own money. So, force yourself into some research and feed yourself from smart people like Jim.
viwi writes “I actually enjoy this mess in Europe. Yet another way of making a buck or two.”
Sure, but how? Any concrete suggestions? I can use a euro-inverse ETF, but not all of Europe is in trouble. Anything better than that?
Christopher,
The key there is that the EU can kick Greece out for failure to live up to the EU’s requirements (and I think they should). If it weren’t for the rest of the PIIGS, the EU would probably kick Greece out.
I don’t see the EU’s union as threatened by Greece alone. And I don’t think they see it that way either.
Actually, I have a quick and semi-painless solution: Have the EU pay Greece to go away. The EU could give Greece enough euros to peg their currency to the euro. Then Greece could make their own currency and distribute it over time, with a specified deadline as to when the euro would no longer be good in Greece. After that time, if Greece wants to inflate their currency, they can.
I actually enjoy this mess in Europe. Yet another way of making a buck or two.
Ed,
It is a good point that the power structure is different. And the “States” having the power does change the dynamics of the power struggle and how the union might split, and such. But my point was more about why the EU wants to hold the union together, even though Greece is such a small part of that union.
What actually happens? The worst of all possible scenarios – Greece would have to live within its means, no more borrowing from future generations (except at loan-shark rates). Greece would have a stained reputation in financial circles until, eventually, all is forgiven. That’s all.
Christopher,
You can’t compare the the U.S. and the EU. EU member states can thumb their nose at EU requirements, even though they share a common currency. U.S. states cannot so easily ignore what the federal government requires of them.
Think about it this way: Who has more power in the U.S.? The federal government. Who has more power in the EU? The member states.
As I see it the EU is not thinking of Greece, they are thinking of other countries on the edge and mostly the EU itself. When you form a union, based on some ideas if any part of the union starts breaking up, you don’t know where it will end, and your union may go with it.
For the people in the US the easy comparison would be if X state was having problems paying its bills would you kick it out of the US no matter how small to the rest of the economy it is? Think of what that would mean to that state, or any other weak state to follow? Not to mention how the US would be viewed to the rest of the world.
Think of the Soviet Union, where is it today? Sure people can certainly say the world is better off without it, but if your whole purpose is to continue it and the beliefs it fostered, then you would certainly look at its collapse as a failure. And look at the pain the all the people had to go through.
For the EU this is about proving that union they created is still a good idea.
Going by the 2009 CIA World Factbook numbers in Wiki, Greece accounts for 0.006% of the world’s GDP.
If there was a brain left in Europe (in addition to Merkel), they would say “Adios Greece!”
The EU accounts for almost 28% of the world’s GDP. Why on Earth would they let Greece drag them down too?
Of course, if I were more cynical, I’d say the EU is overplaying this to get more export business (by driving the euro down), then they can boot Greece to the curb later…
Is there a way out for Greece if they withdraw from the Euro before having to default? A default would be catastrophic. Argentina had a 1:1 peg with the US dollar for 10 years, they defaulted in 2002 and revalued the currency…. But the price paid was 30% unemployment, 60% poverty rate, high inflation, and the middle class wiped out…. the recovery was painful. They learned their lesson.
What actually happens when a country defaults on its debt? Has this happened before?
So, looking down the road, what actually happens if Greece defaults? I know what happens if I default on my car payment or my mortgage, but a government default…can’t wrap my head around that. Are there repercussions that are definite, or would any comment at this point just be speculation?
Jim,
How about a “reset”, or “year of jubilee”, for the developed world ? All these problems are of, by, & for the bankers through their puppet, paid for, politicians.
Look at Iceland. After blowing them up, they’ll come in & aquire all those assets at dirt cheap prices.
The same with California, Greece, Spain, all of Europe, & all of the US. Why let them get away with it ?
Russia, Asia, Brazil, etc, have all defaulted on debt in the last twenty years, & are now in great shape. I think a massive restructuring is the only way to keep developed world from grinding down to much lower standard of living.