The European Union’s contingency plan to deal with the Greek debt crisis was simple enough; it aimed at reassuring investors that the EU would not allow Greece to fail. Like pigs at a trough, global investors were expected to hastily consume that reassurance, along with all the Greek debt that their little piggy banks could afford. The resulting demand for Greek debt would then drive down Greece’s financing costs to levels that even the Germans would envy.
Cautious, however, the EU came up with a contingency plan for its contingency plan. In the unlikely event that global investors got lost on their way to the trough, as many pigs do, the EU and the IMF would join hands, bailing out Greece in unison through a series of market rate loans. In such a scenario, the EU would lead the Greek rescue effort while the IMF would unquestioningly assume a secondary role.
Getting away for a moment from the imaginary land that only EU members and unicorns inhabit, let us now take a look at what actually happened.
The Contingency Plan – Bond Market
The EU contingency plan announced last week failed to meet its primary objective of reassuring investors. Recent activity in the bond market indicates that investors remain doubtful that the EU will protect against defaults by member states. The market’s tepid response on Monday to newly issued Greek debt leaves one to wonder whether sufficient future demand will exist to meet Greece’s debt burden.
For the Monday issue, Greece priced 5 billion euros ($6.7 billion) of seven-year bonds at 6 percent, amounting to a staggering 334 basis point premium over its German counterpart. However, despite its hefty premium, the new issue was oversubscribed by a piddling multiple of 1.4.
Following up on that unimpressive performance, Greece surprised the markets yesterday by increasing its existing issue of twelve-year bonds, which are set to mature in October, 2022. The 5.9 percent yield, however, failed to arouse much demand, raising a dismal 390 million euros compared to an upper limit of 1 billion.
As of 4:15 p.m. in London yesterday, yield on the newly issued seven-years have risen to 6.27 percent, or 27 basis points higher than when they were first issued on Monday.
In the coming weeks, Greece will need to raise an additional 10.5 billion euros to refinance debt set to mature in May. While officials have suggested that they will turn to the bond market for financing, it appears as though the bond market may turn them away.
At this point, it should be clear that the EU’s contingency plan was nothing more than lip service aimed at reassuring the markets. In truth, had the EU coupled that lip service with a symbolic capital commitment, they may have won over investors. Imagine for a moment that the EU had purchased a combined 1 billion euros of Greece’s debt offering on Monday, as a show of faith and unity. While not enough to bring Greece’s financing costs in line with Germany’s, it certainly would have improved demand. Instead, Greece faces slumping demand for its debt and the EU faces far more than a symbolic capital commitment.
The Contingency, Contingency Plan – Joint EU-IMF Solution
Intended only as a “last resort,” the EU’s contingency plan for its contingency plan called for a joint EU-IMF aid package for Greece. The package would offer loans to Greece at market rates and the EU had but one condition for IMF involvement: the EU is in charge. What the EU failed to recognize, however, is that Greece is the IMF’s Moby Dick, offering them the rare opportunity to demonstrate their significance to a developed nation. A secondary, behind the scenes role, then, would be out of the question.
According to a Bloomberg report yesterday, the IMF’s managing director, Dominique Strauss-Kahn, stated that the terms of any IMF assistance for Greece would be decided entirely by the IMF:
Any Greek package would “be an IMF program decided by the IMF as it happens with each and every country,” Strauss-Kahn said in an interview on a flight to Bucharest from Warsaw today. “The IMF will define the conditionality, as we do with any country.”
Mr. Strauss-Kahn went on to say that IMF involvement would be initiated by Greece – not by the IMF or the EU.
Though contradictory to the EU’s proposal, which calls for an EU-led aid program with a limited role for the IMF, Greece would certainly benefit from full-fledged IMF involvement. In fact, their involvement would allow Greece to obtain financing at a lower cost than that which is presently available to them in the open market. However, true IMF involvement would likely force Greece out of the eurozone, as Gain Capital’s research director, Jane Foley recently pointed out. She added, however, that their high financing costs make Greece “more likely to take the usual IMF course of devaluation.”
For Greece, the benefits of an IMF solution cannot be ignored. As investors are sure to demand higher yields on subsequent debt offerings, the bond market is no longer a viable option for Greece to finance its debt.
The Trade – Short EUR/USD
The ongoing Greek debt crisis has led to a recurring theme of uncertainty for the eurozone. Fortunately trading uncertainty is as easy as shorting risk; in this case, the “risk” is the euro.
I advised earlier that the best time to establish a EUR/USD short position, or add to an existing short position, would have been the moment that Greece’s newly issued seven-year bonds hit the market. While the pair has since declined to 1.3400, there remains considerable downside for the EUR/USD.
For minimal risk, a stop just above the highs leading into the bond sale is advised. The pair traded as high as 1.3540, so a stop between 1.3575 and 1.36 is best.
Alternatively, those of you with a higher risk tolerance and/or an established position in the EUR/USD should place your stop far enough away to let the trade play out comfortably, but not so far as to keep you up at night.
Disclosure: Short EUR/USD, Long EUR/GBP