Stumbling at every hurdle

June 18, 2012

Financial markets are odd sometimes. For weeks they have fretted about the outcome of the Greek election and its impact on the future of the euro zone as a whole. But today they appeared to dismiss the outcome despite a result that was about as positive as global investors fearful for euro zone stability could have hoped for.  So what gives?

The logic behind the weeks of trepidation was fairly simple and straightforward. After an inconclusive election on May 6, a second Greek poll on June 17 was due to give a definitive picture of whether Greeks wanted to stay in the euro and with all the budgetary conditions necessary to keep EU/IMF bailout funds in place.  If a victory for parties wanting to scrap the bailout agreement and austerity led to a halt of EU/IMF funds, the fear was that Greece would inevitably be forced out of the single currency bloc in time too. And if that unprecedented event happened, then a chain reaction would be hard to avoid.  If one country goes back to its domestic currency, despite all its debts being denominated in euros, investors would then find it impossible not to assume at least some element of euro exit risk for fellow-bailout recipients Portugal and Ireland and possibly even Spain and Italy, where doubts remain about their market access over time.

Extreme tail risk or not, this set the scene for the jittery markets that ensued during the Greek electoral hiatus of May 6- June 17. Athens stocks lost more than 17%;  Spanish 10-year government bonds lost more than 7% and the euro/dollar exchange rate was down almost 4%. etc. The fear of euro-wide contagion was so-great that the Spanish bank bailout in the interim had a little or no positive impact. And with the global economic growth picture weakening in tandem with, and partly because of, the euro mess, then prices reflecting world demand in general were hit hard by concerns that another shock to the European banking system could trigger a reversal of trillions of euros of European bank lending from around the globe. Crude oil dropped almost 14%, broad commodity prices and emerging market equities lost about 8%.

So, now that it seems likely that Greece will form a government to fight on within the eur0 zone and with — they hope at least– some more benign version of their crippling bailout terms, markets should at least have scaled back some of those losses? Well, no — not yet at least. In fact, Spanish debt yields jumped to euro-era highs — as if to say there was unfinished business elsewhere across the euro area.

And they may well be right in that — but those problems were also there last week and it’s hard to see how they would have been made even worse by the relatively benign Greek vote.

One culprit may have been the fact that from mid-last week, many traders and investors began to expect that a huge injection of liquidity from the ECB and other G20 central banks would greet any market dislocation on Greek anti-bailout vote. Once that became less necessary, there may well have been positions reversed.

Yet it’s striking that, after two consecuative Mondays of damp-squib market reactions to seemingly positive developments, small incremental moves no longer seem sufficient to buy euro governments more time. And while short-term traders may play prices in and around these events, long-term creditors remain on the sidelines and now look like theyt will require a mega fix that deals with the issue once and for all.  So what needs to be seen?

William De Vijlder, Chief Investment Officer at BNP Paribas Investment Partners, said the reasons large investors are staying away from the likes of Spanish and Italian government debt is that they still see too many tail risks. But what’s fast developing is a self-fulfilling prophecy because, by staying away, investors are increasing the risk of the sort of major accident they fear.

De Vijlder said there was only one thing now that he could see working definitively and that was some pooling of European debts.

“We need something more profound to happen to get the feeling that this crisis is fully under control now,” he said. “Some pooling of the debt  is now what the market is demanding and if I had to produce a guess on where we are heading, then that would be it. With a current account in balance, the euro area is self-financing and so some form of mutualisation would surely stabilise the situation.”

The EU summit on June 28/29 will certainly need to make clear one way or the other because little else seems to be working.

 

 

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