Bond vigilantes gone AWOL boost Greek risk of expulsion

The threat Greece poses to Europe may be gaining force through investor complacency.

Money managers are accepting rates on Italian and Spanish government bonds at close to record lows. They’re rejecting the notion that the euro area’s higher-yielding issuers — the so-called peripherals — can be infected by Greece’s negotiations for a new deal on its more than 300 billion euros ($340 billion) in debt. The cues investors are giving to European policy makers may end up backfiring.

“Someone says something that sounds cheerful, and the market assumes that the situation is therefore moving toward resolution,” Stephen Lewis, chief economist in London at ADM Investor Services International Ltd, said in a Feb. 6 telephone interview. “That may not be the case at all. Abandoning austerity in the case of Greece would be abandoning austerity for the eurozone as a whole.”

Investors, far from playing the role of vigilantes who dump bonds and push governments to act, instead are assuming slim chances that Greece will be expelled from the euro. That has emboldened European policymakers, encouraging them to hold a hard line on any debt writedown even if it underestimates the risk that a miscalculation tears a hole in regional financial stability, according to Chris Attfield, a fixed-income strategist at HSBC Holdings Plc in London.

“This lack of contagion is driving periphery tail-risk up,” Attfield wrote in a Feb. 6 note to clients, referring to a low-probability event that would have major impact were it to take place. “The danger is that it encourages the notion that a Greek exit would be survivable for the eurozone.”

Election promise

Greek Prime Minister Alexis Tsipras is set to hold talks on Wednesday with euro-area finance ministers and seek a third debt-restructuring in three years. The 40-year-old is clinging to a promise that swept him to power on Jan. 25, namely to end social-spending cuts imposed on Greece under the bailout program set up by the European Union and International Monetary Fund.

Since his victory, Tsipras has vowed to increase the minimum wage for Greeks, restore the income tax-free threshold and halt infrastructure privatizations, while saying he will ask for World War II reparations from Germany — none of which has been embraced publicly by his euro counterparts.

German Chancellor Angela Merkel has signaled little willingness to compromise with Greece over the conditions attached to its bailout.

‘No way out’

“There is no way out” of those obligations, Michael Fuchs, a deputy caucus chairman for Merkel’s Christian Democratic Union in parliament, told Bloomberg Television in an interview. “We have a full disagreement at the moment, because what they want to do has nothing to do with all the agreements which have been made.”

While Tsipras’s campaign promises appeal to Greece’s austerity-weary voters, investors seem less keen. Even though he vowed that Greece will honor its debts to private bondholders, stocks have whipsawed and notes have plunged, shooting yields up to levels not seen since its 2012 debt restructuring. The rate on three-year Greek debt climbed for a fifth day on Tuesday, to 21.91 percent, at 7:40 a.m. in London. The ASE Index of stocks dropped 4.8 percent the previous day, bringing its loss since Tsipras came to power to 9 percent.

Chancellor of the Exchequer George Osborne said the danger of a miscalculation leading to a “very bad outcome” between Greece and the euro area is increasing, and the Group of 20 finance ministers are urging a solution.

Risk of misstep

“It’s clear that the risks to the world economy, the risk to the British economy of this standoff between the eurozone and Greece, is growing each day,” Osborne said in an interview with Bloomberg Television in Istanbul late on Monday. “The risks of a miscalculation or a misstep leading to a very bad outcome are growing as well.”

The extra yield investors demand to hold 10-year Spanish and Italian government bonds rather than German bunds reflects limited Aegean-induced anxiety.

While Italy’s yield spread had widened 14 basis points since the vote through Monday, to 131 basis points, it remained at less than a quarter of its 546 basis point peak in the months following Greece’s 2012 elections. Spain’s spread over bunds has climbed 20 basis points since Jan. 23 to 121 basis points. It has fallen from as much as 650 basis points in July 2012.

The European Central Bank is helping to shield Greece’s peers from a bond market selloff as investors anticipate the start of President Mario Draghi’s 1.1 trillion-euro bond-buying plan in March. The average yield on euro-area government debt dropped to 0.6343 percent on Feb. 4, the least since at least 1995, according to Bank of America Merrill Lynch indexes.

Liquidity threat

Even as it holds down yields of the euro-area’s peripheral debt, the central bank ratcheted up pressure on Greece to reach a solution by restricting its banks’ access to direct liquidity lines last week.

That move triggered fresh volatility in Greek bonds, pushing the three-year yield up as much as 354 basis points during the following day and sparking a four-day selloff. Yet it caused few tremors within the euro-area’s higher-yielding debt markets. The yield premium on Portugal’s 10-year bonds over German bunds declined 30 basis points last week.

Even so, the risk of contagion remains as talks drag into a third week with no sign of Greece capitulating on its demands for a better deal on its debt. That’s encouraging other countries to look at the terms of their bailouts.

“Of course we will insist that any new or better deal applies to Ireland as well as Greece,” Irish Agriculture Minister Simon Coveney said in a RTE Radio interview on Monday. “We have to make sure that the same rules apply to Greece as to everybody else.”

Spanish austerity

Spain in particular may attempt to scale back its austerity policies because of the similarities between its insurgent opposition party, Podemos, and Tsipras’s Syriza party, according to Thomas Elofsson, who helps oversee helps oversee 353 billion Swedish kronor ($42 billion) as a money manager at Skandia Investment Management AB.

“You might see rising similar political movements,” Elofsson said in a Feb. 5 telephone interview from Stockholm. “It’s a bit too early to start pricing in these risks of contagion. You have to see how the political situation develops in these countries first.”

With talks deadlocked before an emergency meeting on the region’s finance ministers in Brussels on Wednesday, the Greek crisis is likely to remain at the forefront of investors’ concern, even if that fails to translate into peripheral bond markets.

“There’s a danger everyone is too complacent on this,” Steve Barrow, the head of G-10 strategy at Standard Bank Plc in London, said in a Feb. 6 telephone interview. “The eurozone officials are saying there’s not really a substantial contagion threat and maybe that lulls the market into a false sense of security. That maybe then rebounds back onto the eurozone officials to basically think ‘we’re actually right about this!’ It’s difficult to see how the situation will be resolved.”

[Bloomberg]