Absence of contagion changes whole Greek game

If fear of Europe-wide financial wildfire was Athens’ trump card in its standoff with euro zone creditors – then the card has now turned up a dud.

The merits of ruling socialist party SYRIZA’s demands aside, its brinkmanship in renegotiating the painful terms of its international bailout always required one key element – a finanacial version of the old Cold War doctrine of “mutually assured destruction.”

A reprise of 2010/2011 would have seen any threat of Greek default or euro exit infecting markets everywhere and sending government borrowing costs across Italy, Spain, Ireland and Portugal soaring, heaping pressure on the Eurogroup to move closer to Athens’ demands to prevent a systemic euro collapse.

“Whoever gets scared in this game loses,” Greek Prime Minister Alexis Tsipras said this week as a three-month impasse threatens cash shortages ahead of critical debt repayments.

But the much-feared financial contagion – dubbed “euro crisis 2.0” by forecasters at the turn of the year – has not materialized for euro zone governments sitting across the table.

And few if any investors expect the talks to be electrified by any sudden market blowout – eye-watering gyrations in local Greek markets notwithstanding. Borrowing costs across the euro zone hover near record lows, euro zone equities are within a whisker of 7-year highs and the euro currency has held in a five-cent range for two months.

That’s all the more remarkable given how negative markets have turned on the outlook for Greece itself.

Almost half of all investors polled by German research group Sentix this month expect Greece to leave the single currency within 12 months, while the survey’s index measuring the risk of contagion to other parts of the euro zone fell to a record low.

“Greece is not capable of derailing the euro zone recovery nor is there a real risk of contagion to the periphery,” reckons Wouter Sturkenboom, strategist at the $272 billion asset manager Russell Investments.

Most scenarios sketched by banks and fund managers still center on some progress in talks or some protracted limbo involving some limited Greek default within the zone.

But even though exit is now a real risk, the gloomiest forecasts look mild compared to the chaos of three years ago.

Goldman Sachs says “Grexit” – which they don’t expect to happen – could see Italian and Spanish 10-year bond premia over Germany more than trebling to as much as 400 basis points.

That’s about 200 basis points shy of peaks hit during the winter of 2011/12. And given German 10-year borrowing rates are near zero, those spreads would imply nominal borrowing costs for Italy or Spain 300 basis points below peaks of three years ago.

QE stabilizer

Critical is the fact that foreign private exposure to Greek assets has dwindled since the default of 2012 and the bulk of Greek debts are now owed to other euro governments, the ECB and International Monetary Fund.

But regional calm is mainly thanks to several euro-wide emergency firewalls – such as the European Central Bank’s Outright Monetary Transactions or the European Stability Mechanism – built painstakingly over the past four years.

Chief among them is the trillion euro bond buying, or “quantitative easing” program launched just last month.

“QE is probably the primary defense against contagion,” Deutsche Bank economist Mark Wall told clients.

By accident or design, the ECB’s rationing of QE via its so-called “capital key” has an in-built stabilizer of its own.

That model means the ECB is set to buy more bunds than anything else with its 60 billion euro per month splurge to September 2016. But, partly as a result, three quarters of all bunds now yield less than zero and a quarter of that universe is illegible for QE purchases because yields are under the -0.2 percent threshold below which the ECB refuses to buy.

That has two implications. Any prior euro shock typically herded euro domestic investors to the perceived safety of bunds. Now they face blindingly expensive securities that even bond guru Bill Gross last week called the “short of a lifetime.”

But more powerfully, the growing inability of the ECB to buy bunds will likely force it to alter its capital key and skew purchases more toward the large, higher-yielding peripheral bond markets of Italy and Spain – further protecting these markets in the event of any Greek shock in the interim.

Without a spike in borrowing rates, shocks to business confidence and investment that whacked equity markets last time round are muffled.

It’s possible mutual or hedge funds shift money out of the bloc altogether. But the main result of that would be pressure on an already weakened euro exchange rate – a move likely cheered rather than booed in the rest of Europe as it underpins economic recovery and wards off deflation.

Some say the bigger risk from SYRIZA’s rise to power was political rather than financial contagion – emboldening anti-austerity movements across Europe, such as Podemos in Spain, and stoking euro skepticism and existential threats to the currency.

But chaos in Greece, no financial shock elsewhere and no concessions from Brussels could well have the opposite effect.

“There is no other Greece and there isn’t quite another SYRIZA,” JPMorgan economists told clients, pointing out the only popular anti-austerity party seeking euro exit was Italy’s Northern League. “The disorder unleashed by Greece’s exit would probably dampen support for these parties and reduce rather than increase the odds that others follow its lead.” [Reuters]

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