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Drachmageddon: Is The Greek Tragedy Reaching A Grand Finale?

Consensus is building that a Greek departure from the euro zone is a question of 'when' rather than 'if'. However, the potential ramifications of a 'Grexit' are chilling, especially for a global economy which is already flagging. Will this force Europe to step back from the edge?

Radio Arvyla, a Greek television comedy, broadcast an episode last November in which the drachma was launched into outer space in 2001, only to fall back to earth a decade later to cause chaos and destruction throughout Greece. As the war drums signaling a Greek exit from the euro zone grow increasingly louder, the parody, entitled 'Drachmageddon', is looking more and more likely to come true. Two banks have now even announced specific exit dates; Citibank's chief economist advised that Greece would abandon the euro on January 1st 2013, whilst the Bank of Tokyo Mitsubishi-UFJ were even more ambitious, announcing last week that Greece will leave this week-end, on June 2nd.

There is definitely a feeling in the markets that we are heading for some sort of resolution (although not necessarily a positive one) to this extended Greek tragedy. Investors are voting with their money, which is leaving Greece (and, even more ominously, leaving other peripheral countries as well) with alarming speed. From a political perspective, there appears to be little common ground between the Greeks and the German government (who, as the de facto paymasters of Europe, will have a large say in how this saga is ultimately resolved). Whilst the 'pro-austerity' parties in Greece do seem to be edging it in the polls leading up to next month's election, it is worth remembering that even these parties have indicated they want to look at re-writing some of the austerity and reform measures which form the basis of the Greek bailout; something that is an anathema in Germany (where 60% of Germans now want Greece out of the euro zone). Furthermore, there is speculation that the markets may force a conclusion before the Greek election in any case, as capital drains away from Greece in what is a essentially a classic 'bank run' in sovereign form. (Newedge, a leading prime broker serving the hedge fund community, announced last night that they would only be processing 'sell' orders for Greek securities, effective immediately).

Whilst we view a Greek exit from the Euro as a strong possibility, we would still put the probability of such an outcome occurring this year at less than 50%. From a Greek perspective, there remains a strong desire to remain in the Euro. Greek opinion polls currently show that approximately 80-85% of Greeks have no desire to abandon the euro (although they remain less attached to the austerity measures which go along with the single currency). As such, it would be highly unlikely that any Greek government (even one lead by Alexis 'Che' Tsipras) would sanction a move that would be so unpopular amongst the Greek electorate.

It is more likely that any Greek exit would be engineered by European leaders (chiefly Germany) who increasingly view Greece as a lost cause. As Greece still runs a primary deficit (meaning that, even without debt service obligations, the Greek government still needs to borrow money to operate on a day-to-day basis), Europe (via the ECB) could essentially 'pull the plug' at any time, forcing Greece to either implement immediate and draconian cuts to essential public services, or begin printing its own currency. Europe has been increasingly clear at hinting that this option is very much on the table, should Greece decide to push back on the implementation of the agreed austerity measures which are proving so unpopular. However, there is a good chance that this talk is merely a bluff, designed to scare the Greeks into fulfilling their obligations under the bailout packages. For all the talk of a Greek exit being 'manageable', the consequences of such an action are unknown, and the risks are high. As historian Niall Ferguson commented recently: "Even if just one country leaves the euro zone, that creates a massive contagion effect, and no one knows where the ripples would stop - it could even be a tsunami that hits New York."

Whilst European leaders have consistently underwhelmed in their efforts to contain and resolve the crisis to date, it still seems that committing such an irresponsible act, with such potentially grave implications for the global economy, is a step too far. Surely, donating a few more billion euros to the Greeks in the name of European solidarity is a lesser price to pay (after all, they're already in for about a quarter of a trillion!).

EURUSD and GBPEUR Collide (again):

(click to enlarge)Click to enlarge

From a technical perspective, the EURUSD and GBPEUR charts have collided twice since the onset of the financial crisis in 2007 (when they first crossed) (see chart). Interestingly, on both prior occasions they collided as heightened levels of risk aversion prompted a wave of USD purchasing (mainly against the EUR). In both cases, a perceived resolution (either via QE in 2008 or the Greek bailout in 2010) resulted in a strong resumption of the 'risk-on' trade, boosting the EURUSD and causing a sharp sell-off in GBPEUR (in both cases, GBPEUR dropped from the mid 1.20s to 1.10 or below).

Could a 'resolution' to the current Greek crisis result in a similar move this time? It is not an outcome we expect (as demonstrated by our EUR bearish bias), but is worth watching closely. If Europe were to act decisively to get the Greek situation under control (e.g. launch a euro-area bank deposit guarantee scheme, move towards an effective fiscal transfer framework etc.) it would be entirely likely that EURUSD and GBPEUR would continue to act like two positively charged magnets, and strong reversals could occur in both currency pairs.