Greece: What to Believe?

|
 |  Includes: ERO, FXE, GRDOW
by: Harry Tuttle

As I wake up this morning I hear my favorite news broadcaster (NPR, if you must know) proclaim something to like: "Markets are rallying overseas on news that the IMF has announced a $150B package for Greece." (The NY Times version is here.)

After a quick breakfast I rush to my computer to check prices. The rally still has the euro below US$1.33. My brokers, however, are all tripping over each other to bombard me with messages showing Greek CDS' at 520-620 (that is -150 from last night, dude!!). I even have one that says "...eveything back to normal !" (sic)

Wait a minute! Didn't they announce this package before? How much money has Greece actually received from the IMF or other European sources? The answer, so far, zero. In fact, the structure is exactly the same as with the "previous" package. Somebody throws a big number in order to calm the markets hoping to scare the pernicious buyers of Greek CDS's into taking profits and forcing Greek yields down. At this point, everyone in the global market is glued to their CDS screen. Except the truth is to be found elsewhere. (Click to enlarge)

The columns on the right above (source: Bloomberg) show the bid-ask yield for Greek government bonds. As one can see, the curve for maturities longer than two years is inverted (higher yields for shorter maturities). In general, a non-risk free credit shows an inverted yield curve when the bonds trade by price and no longer by yield. In other words, unless the risk free rate is also inverted (not the case as shown by the swap curve on the left) the inverted curve signals that the market is concerned about default. In this case, it is apparently more concerned after one year.

This curve became inverted a couple of weeks ago and it is still inverted this morning as I write this. The question is: Why wouldn't European investors rush to buy 2-year paper at 12.7%? I mean, the difference between Greece and Germany can give you an extra 10% per year. Not a bad deal if you believe that Germany will bail out Greece. Same credit, much higher yield. The answer is partially explained in the NY Times today ("Already Holding Junk Germany Hesitates").

German institutions already own US$50B of Greek paper, which brings us back to the inverted curve. I do not know about you, but if I was the treasurer at a German bank sitting on a pile of Greek debt accumulated during the boom years, not only am I not buying more but I am also, quietly, looking to sell some. Maybe I am even trying to hedge my risk by hiding a few Greek CDS' in the closet.

There are more than a couple of players in this Greek Tragedy (sorry, I couldn't resist). The IMF, with Brazil becoming a financial powerhouse, has been out of a job for a while. Thus, they would love a center stage engagement monitoring Greek finances. The Germans, knowing how much Greek debt they already own, would love for the market to rally behind the Greece-IMF team one last time so that they can unload their bonds (how do you say: "never again" in German?) without having to actually lend Greece much money (Remember Hank Paulson's bazooka?).

If history is any guide, the Greeks will never deliver on the austerity packages. You can look this up, there is no precedent for an adjustment of this size (Deficit > 10% of GDP) without a devaluation.

The bottom line is that if the Greek economy could not raise the tax revenues to balance its budget and service its debt in good times with rates under 3%, I do not see why one should expect them to close the gap with higher rates and a weakening economy. The IMF and Germany may be able to refinance the Greek debt and keep creditors happy for a long time but it is unlikely that they will ever be able to make the Greeks balance their budget. Maybe Greece will show that this time is different, but in my opinion, this is all about buying time until the Germans can find a solution for their banks.

Disclosure: No positions in Greece