From Goldman Sachs:
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.
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.
…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?
Very amusing. In short, a Grexit doesn’t matter until it happens and then it’s all that matters. Ah, markets, the world’s worst discounting mechanism, with the exception of governments.