Guest Post: Let’s Dance Sirtaki On The Liquid Dance Floor!!!

You’ll find the ever widening CDS on
the fast-growing Hellenic debt. Rather frightening considering that CDS
are revisiting march levels (remember: markets were scared by the slump
in eastern Europe economies and numerous rumours on the blast of the
euro were flourishing).

Today it seems that those fears
are materialising: Ukraine is in a deep syncope (borders have been
closed for two months due to the H1N1 pandemic) and Greece could be
deeply impacted by the unwinding of the liquidity-driven ponzi on the
Hellenic market. While this piece of news could be harmless for HFT or
robot traders, it is also completely put aside by fat portfolio
managers happy to eat up low priced turkeys for thanksgiving (-30%!!!).
The EURUSD is flirting with recent highs (like a turkey dazzled by the
headlights of the euphoria-maniac rally car).

The excellent Researchahead blog was the first one to highlight the Greek fire (please read http://www.researchahead.blogspot.com/) for a very interesting comment on the latest Sirtaki dancefloor.

The underperformance of Greek
assets has continued over the past days. In the bond market, 10y
GGB-Bund spreads have widened sharply to currently around 174bp from
132bp just two weeks ago and a low of 108bp in early August. As the
chart below shows, this spread widening has been mirrored by wider CDS
spreads for Greece. Interestingly, the absolute level of the Greek CDS
seems to top and bottom ahead of the GGB-Bund spread. In early March it
peaked 9 days ahead of the top in the 10y GGB-Bund spread and in early
August it bottomed 7 days ahead of the low in the cash-bond spread.
What is more, the relative performance of equities seems to lag the
developments in the bond markets (I used the difference in the
percentage-performance since the lows in the equity indices on March
9). Greek equities have only really started to underperform since late
October, i.e. more than two months after the outperformance of Greek
GGBs came to a halt and started to revert.

This highlights once again that
equity investors ignore the developments in bond markets at their own
peril. Furthermore, given that the underlying problems responsible for
the latest underperformance are also present in a host of other
countries, bond and equity investors should take note. First, Greece is
suffering from a structural weak economic position (significant
imbalances, low relative competitiveness etc.) coupled with limited
room for an ongoing environment of stimulative fiscal as well as
monetary policies. Fiscal policy is seriously constrained by the high
level of indebtedness and the exorbitantly high budget deficits. In
turn, fiscal policy needs to be tightened significantly just to
stabilise the deficit near 10%. This, however, will further harm the
economy. Moreover, monetary policy is far from exerting the same level
of accommodation as in other countries. The level of longer-term
interest rates is higher with 10y Greek government bonds yielding 170bp
more than their German counterparts (vs. a pre-crisis level of roughly
35bp) whereas the inflation differential has decreased (currently 1.2%
difference in headline inflation rates vs. an average of 1.55% over the
past 10 years). In turn, the monetary environment for Greece is
significantly less accommodative than it is for Germany. Moreover,
Greek banks seem to rely relatively more on the ECBs liquidity
providing measures. As this FT article suggests – citing a BNP Paribas
research piece – 7% of excess reserves provided by the ECB have gone
into Greece which only represents 0.9% of EMU GDP. Furthermore, Greek
banks seem to have used this liquidity to buy local government paper
helping sovereign spreads come down.

However, similar problems
(significant structural imbalances, high deficits which will need to be
reduced via fiscal tightening, lower level of monetary policy
accommodation than for the Eurozone average, high reliance on ECB
liquidity providing measures) are apparent in a host of Eurozone
countries. I continue to see the largest problems – besides Greece -
for Ireland, Portugal and Spain. I still remain a little less worried
with respect to Italy (largely because the deficit still appears
relatively low which means that there is no need to actively tighten
fiscal policy as of yet).

Given the structural economic
imbalances coupled with the need to tighten fiscal policy, monetary
policy would be more important for those countries to deliver ongoing
policy support. But again, the level of interest rates in these
countries is significantly higher (especially in Ireland) than in the
core of the Eurozone. Coupled with lower inflation rates than for the
Eurozone average (-1.5% for Portugal, -0.7% for Spain,-6.5% for Ireland
vs. -0.1% for the Eurozone) this means that real yields are much
higher. Furthermore, this high level of real interest rates is
especially apparent at the long end of the curve given the high level
of credit spreads on top of the already steep underlying yield curve
(as measured via Bunds or swap rates). This renders it much more
attractive for the banks located in these countries to use the
short-end of the yield curve to refinance than locking in rates at the
longer end. As a result, I assume that the dependency on the ECBs
liquidity provision measures tends to be higher in those countries on
average (this is not to say that for example also some weak German
Landesbanks do not rely extensively on ECB liquidity). In turn, as the
ECB starts to withdraw this liquidity, it will be especially the
banking sectors in those weak countries which will suffer
significantly, leading to further underperformance of respective bond
and equity markets.