Friday, 30 April 2010

A couple of Greek lessons

Greece has taken all the headlines in the past week. Greek government bond yields have soared and so have the price on CDS's, also known as default protection. S&P downgraded Greek government bond yields to junk status. The air has been thick with rumours of an imminent default. The Greek government yield curve took the shape seen in countries just before a default: Short yields much, much higher than the yield on longer-dated issues.

All of this happened against a backdrop of an agreed standby facility offered by IMF and the European Union.

So we have now seen most of the financial markets and one of the 3 (American) rating agencies basically telling IMF and the European Union: we do not believe in your rescue plan. True, a number of European politicians have been trying to make some political mint on denouncing the Greek people/politicians profligate ways. True, the German government has not been forthcoming in terms of the soothing messages the market wanted to hear. True, the Greek government has met determined resistance to any cutbacks. All of this has of course created a fertile ground for rumours and half truths. Both are important elements in a good market run on something, be it a weak company, a currency, or the debt of a country.

There are many aspects of the Greece story. One is the potential viability of the current Eurozone. That is a subject for the longer term. In the short term, there are two lessons that market will probably have to learn. One is: don't mess with us! If the EU governments, led by Germany say that they will put a hand under Greece's debt, it means that they will actually do so. ECB and the German/French governments will with great gusto enjoy if speculators lose their shirt here.

It is my guess that Germany's Chancellor Angela Merkel will have some special consideration for S&Ps downgrading of Greece. As early as 2008, when the insidious role of the ratings agencies in creating the the Sub-Prime debacle, Ms Merkel pointed out that the ratings agencies were for-profit institutions and that the European Union ought to create an independent rating institution. S&P's description of the IMF/EU support package for Greece was described as "revocable". This choice of words is a direct challenge to the EU's resolve and is bound to reinforce the impression that S&P's downgrade was politically inspired. We will see.

The other lesson is that the financial markets may finally be waking up to the uncomfortable reality that default risk is a fact of the day. For the past decade, risk has almost been considered equal to the short term interest rates: when rates are comfortably low, we do not have to worry too much about risk, so let us add some. For the technically minded: When market volatility (or one of its derivatives, such as Value-At-Risk) is low, risk is low. I believe that the way the stock markets shook off the speculative selling of Greek bonds is a valuable signal. A general widening of the credit spreads would be another indication that a reasonable pricing of risk is on its way back.