Greece: It’s All About Debt Relief Now

Market reaction was fairly subdued following the weekend’s historic referendum that rejected the Troika’s offer. The ball is now in Greece’s court as the government must provide a new proposal. The key question is whether creditors are willing to offer meaningful debt relief.

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The Greek government is willing to accept more austerity, but only in exchange for debt relief in some form. The problem is that Greece’s creditors can’t offer more than a token reduction in debt because of the moral hazard problem; other countries in the currency union may then also demand “a better deal”. On Greece’s side, the country can get maximum debt relief via default, giving it a strong incentive to hold out.

Our geopolitical strategists still estimate the probability of Grexit to be 20-30%. If Greece heads down the exit path, we believe that global markets will likely see the country as an outlier in the near term. Contagion to U.S. financial markets will likely be minor, unless the euro breaks down and sends the U.S. dollar sharply higher.

As for Peripheral sovereigns, the risk/reward balance is not very attractive at these levels. Our global bond service remains underweight the sector versus core European bond markets. Spreads have widened by about 50 basis points over the past couple of months, but they still do not offer value good enough to justify gambling that the Greek situation will come to a speedy and smooth conclusion. The government’s use of IOUs to pay its bills domestically would signal that the situation could hang over investors for another long while.

We would be tempted to buy Portuguese, Italian and Spanish bond spreads if they were to widen another 50 basis points, or if the Troika signals that it is willing to provide meaningful debt relief.

Nonetheless, we would view any purchase of Peripheral debt as a tactical trade rather than a strategic buy-and-hold. BCA’s Global Investment Strategy service argues that investors could begin to question the view that Greece is an outlier when Eurozone economic growth slows, debt/GDP ratios start to rise again and voters in the Periphery refuse more fiscal austerity. The saga continues.

Bond Market Liquidity Will Not Get Any Better

The deteriorating state of bond market liquidity has been a dominant concern among bond investors in 2015.

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Given how expensive it has become to enter and exit bond positions, especially in the cash market, there is a lot of investor angst over the ability of bond markets to handle a period of severe selling that could unfold if the Fed does indeed begin to lift rates in September. The greatest fear of both investors and regulators is that a “fire sale” of debt could occur if outflows from bond funds were to accelerate, forcing portfolio managers to sell bonds to raise cash to meet redemptions. This scenario could create a cascading wave of selling pressure on bond prices, most notably in heavily-owned corporate bonds.

We continue to believe that the risk of Fed liftoff is the biggest threat to credit markets, as there are already signs that the correlation between credit spreads and Treasury yields is turning positive, as has occurred during every run-up to Fed liftoff over the past 25 years. Nonetheless, the risk of a “fire sale” of bonds in corporate debt markets is overstated, in our view. Please see the next Insight, (Part II) Bond Market Liquidity Will Not Get Any Better.

Greece Referendum: Bank Closure To Focus Minds

The weekend’s dramatic events in Greece have increased the probability of ‘Grexit’ from 5-10% to between 30-40%. Investors should be prepared for a risk-off environment as a market riot produced by a referendum or even an early election in Greece may be necessary to get both sides to a ‘Yes.’

BCA’s geopolitical strategists will publish a report later today on the situation in Greece and what it means for investors. The Special Report will be sent to all BCA clients.

The Report addresses 10 key questions including:

  • Can Greece cause a meaningful correction in global equity markets?
  • What is the timeline of key events?
  • Can ‘Grexit’ produce substantive contagion beyond sentiment?
  • What should investors do?

Handicapping the referendum is extremely difficult. Two recent polls suggest that a robust majority (50-60%) of Greek citizens supported the June 22 proposal submitted by Tsipras to European creditors. The subsequent rejection and revision of that proposal by the IMF and Eurogroup increases the likelihood of a ‘No’ vote. However, the inability of Greek voters to access their bank deposits will likely focus minds and encourage them to vote ‘Yes’.

Negotiations will continue until the Greek central bank is instructed by the government to physically print new currency. Credit controls, default, even the issuing of IOUs are all simply steps that take Greece closer to a crisis, but are not by themselves critical. A clean break from the euro is not imminent even if the vote is ‘No’.

In the near term, we expect that ‘risk off’ will dominate market trading. Sources of uncertainty are rising, especially in the context of a looming Fed rate hike and elevated equity market valuations.

In the medium and long term, Greece’s exit from the euro area would have a minimal impact beyond the immediate turbulence and shock to European business confidence. BCA’s Geopolitical Strategy and Global Fixed Income Strategy services have recommended underweight positions in peripheral bonds versus the core market, but we will view any significant spread widening as a buying opportunity.

Please see today’s Special Report for all the details.

Treasuries After Liftoff: Breadth Of The Recovery Matters

Fed Chair Yellen has repeatedly stressed that rate hikes will proceed “gradually” and the committee’s median forecasts call for only four 25bp rate hikes in the first year following liftoff and five in the second. The extent to which this expected pace is realized will ultimately determine whether a prolonged bear market in Treasuries ever materializes.

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Our U.S. bond strategists contend that it is not just the pace of U.S. growth that will determine whether the Fed’s projected path is realized, but the global breadth of the recovery will also play a key role. This can be illustrated by examining the differences between the aborted 1997 rate hike cycle, and the most recent 2004 rate hike cycle.

The U.S. economy was performing well at the time of liftoff in both 1997 and 2004, as evidenced by the leading economic indicator (LEI). The growth in the LEI is similarly robust today. However, the Global LEI Diffusion Index, which is calculated as the percentage of 23 countries with an increasing LEI, plummeted following the 1997 Fed rate hike, even as U.S. growth remained strong. This divergence in economic performance sent the dollar surging, which prevented the Fed from lifting rates again. In contrast, the Global LEI Diffusion Index troughed around the same time as the Fed began to hike rates in 2004. The wider breadth of the global recovery in that cycle meant the U.S. dollar could depreciate, forcing the Fed to hike more.

The point is that large currency movements have the power to ease/tighten monetary conditions, even without a change in interest rates. If the U.S. is the only country exhibiting solid growth, then most of the Fed’s tightening will be accomplished through an appreciating exchange rate, and the pace of rate hikes will be lower. Conversely, a synchronized global recovery and a stable or depreciating dollar, will put upward pressure on the pace of rate hikes in the year following liftoff.

Bottom Line: The median FOMC projection calls for four rate hikes in the first year following liftoff. Watch the U.S. dollar’s reaction to the first rate hike to gauge the likelihood that this projection can be met.

Is The Fed A Real Threat To EM?

A common assumption among many market commentators and investors is that emerging markets (EM) are vulnerable because of expected rate hikes by the U.S. Federal Reserve. Although intuitively this thesis seems reasonable, our EM strategists note that history does not bear it out.

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In the past, EM vulnerability has not stemmed from Fed tightening. Over the past 20 years, EM risk assets – stocks, currencies and credit markets – typically performed well during periods of Fed tightening and sold off during episodes of easing.

Generally, we believe Fed policy could alter investor sentiment and capital flows to developing countries, and hence influence EM financial markets in the short run. However, in the medium and long term, fluctuations in EM interest rates, equities, credit markets and currencies are largely explained by EM domestic fundamentals rather than Fed policy, please see the next Insight, , (Part II) Is The Fed A Real Threat To EM?.