Markets Hanging in there but Greece is Pandora’s Box


Am I hopelessly sanguine or is the market holding in quite well at the moment given all the headwinds that are facing it? It strikes me that my hypothesis that the volatility over the past few months is good for market structure may actually have some traction here at the moment as we slide inevitably toward some form of Greek default.

Indeed I would argue that the reaction to what is going on in Europe at the moment is very interesting.  Yesterday afternoon’s Asian selloff after comments from German (got to make the bailout fund bigger) and Irish (bond holders should share in the losses of the Irish banks) officials wasn’t really followed up to any decent amount in trade. Sure in London the FTSE ended down 0.76% but in Germany the DAX was off just 0.7% and in Paris the CAC fell only 0.38%. How can it be that at the epicentre of this global crisis, well within a few hours flying time anyway, that markets are holding up so reasonably well.

Could it be that because this is such a slow motion train wreck that investors are appropriately positioned for the coming default, semi-default or default that isn’t really default.

I think the answer has to be yes, at least in some part.

In the piece on instability I noted above I suggested that it was actually good for markets and that the big moves across many markets, equities, commodities, bonds and so on over the past few months meant that a lot of hot money had moved to the sidelines and thus the size of positions that need to be unwound if, when?, we get a Greek or Irish default meant that the so-called “risk-off” event would not be as bad as we could have feared.

While this means that short-term traders are driving skatty markets more than normal I still hold that this is probably true.

But something I hadn’t considered, because I assumed that investment banks had learnt the lessons of the GFC, was just who is writing the insurance on Greek debt that investors and punters are buying to protect or profit from a Greek default. In the past few days though as discussions about whether there will be a default or not or if there is a default what form it will take and who will lose out have been had I am increasingly seeing that while European Banks are largely exposed to PIIGS defaults through the physical bonds. But across the pond it is the US banks who have been writing insurance, CDS contracts, against Greek Debt (BIS data so credible) so  potentially they are going to be dragged into this as well and in a big way.

Greece is still on the precipice and with it global markets and economies. But hopefully the slow motion nature of this drama will insulate us from the impact. But here is how Ben Levett from Forecast summarised his piece that alerted me to the size and scale of US CDS exposures. It food for thought.

Greece remains a potential Pandora’s Box with potentially unpredictable knock on effects and that deal will not be the end of it but likely set the bar for the next round of renegotiations. Whatever benchmark is set for Greece will inevitably spillover the Portugal and Ireland, evident in the ever rising bonds correlations and ‘betas’ in recent days as the latter sees larger yield mark ups for every rise in Greek indicative yields. With the UK’s 30% exposure to Ireland, that risks further widening the net on knock on contagion, at least within financials. Kicking the can down the road seems to be coming to the end of the track as ‘extend and pretend’ brings its own potential dangers of undermining the liquidity and pricing of a broader range of underlying and hedging instruments. If trust and liquidity in the bond market were to break down afresh, in post Lehman’s style, the last resort would inevitably be a surge in alternative short risk protection, seeing currency and equity volatility also surge. Finally, any concerns over broader European bank stability, and any hard line ECB stance in cutting funding access to Greece, could also have knock on impact in terms of European banks access to cheap USD funding, a key trend during the QE2 phase helping EUR/USD when spreads widened. In that event, the reversal in the USD would be even more extreme.

Pandora’s Box indeed, I hope this is not a pre-Lehmanesq moment for markets. But it mightn’t matter anyway the data in the US is turning really bad. Last nights Philly Fed was -7.7 from 3.9 and against expectations of +7. So far the Dow is holding above its trendline as you can see on the chart below.

If that breaks then we might see a real risk off event. But for now markets are holding together pretty well.

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