A Look At Greek Contagion Risk

|
Includes: EU, FXE, VGK
by: Chris Puplava

Summary

Currently there is no contagion from Greece but that could change quickly.

Barring a true financial contagion the worst case scenario is likely a market correction.

As Warren Buffett said, "only when the tide goes out do you see who has been swimming naked." Right now the tide remains.

Talks between Greece and its creditors broke down over the weekend and Greece's banks and stock market were closed Monday and will likely remain closed all week. A brief overview of the Greek situation is provided below from a Reuters article:

Greece in shock as banks shut after snap referendum call

Stunned Greeks faced shuttered banks, long supermarket lines and overwhelming uncertainty on Monday as a breakdown in talks with international lenders plunged their country deep into crisis.

With Greece's bailout expiring on June 30 and an IMF payment falling due at the same time, Prime Minister Alexis Tsipras pleaded in vain by phone with European officials to extend the program until a referendum on July 5 on its future terms.

The frantic efforts to secure Greece's place within the eurozone followed a dramatic weekend. Tsipras's decision, early on Saturday, to put the aid package to a popular vote took the lenders by surprise and sent Greeks rushing to cash machines.

It also pushed Greece toward defaulting on 1.6 billion euros ($1.77 billion) due to the International Monetary Fund on Tuesday, which would take it closer to an exit from the eurozone. A Greek official confirmed to Reuters that the payment would not be made.

Greeks - used to seeing lengthy talks with creditors end with an 11th-hour deal - were shocked by the turn of events. Queues snaked outside ATMs and inside supermarkets while fears of disruptions to fuel and medicine supplies grew…

After months of talks, Greece's exasperated European partners have put the blame for the crisis squarely on Tsipras for rejecting a package they consider generous. The Greek side argues that pension cuts and tax hikes demanded of it would only deepen one of the worst economic crises of modern times in a country where a quarter of the workforce is already unemployed.

A snap Reuters poll of more than 70 economists and traders taken on Monday put the probability of Greece leaving the eurozone at 45 percent, up from 30 percent a week ago.

I'm closely monitoring the situation in Greece as well as the global financial markets for signs of contagion risk. Prior to this weekend's events I surveyed the credit markets to see if there were any building signs of stress in the financial system (click for article link) and the takeaway was that there was little sign of stress so far. That said, a lot can change in a short amount of time as this weekend's developments highlighted and I took a fresh look at the credit markets to see if this weekend's events were causing risk levels to elevate.

One measure of risk shown below is credit default swaps (CDS) which are used to hedge against default risk. If a financial crisis was developing with the potential for Greece to exit the Euro we would see a spike in CDS insurance on other financially and economically weak European countries like Portugal, Italy, Ireland, Spain and France. As seen below, CDS levels for the aforementioned countries are nowhere close to the levels seen back in 2011 when the Greece crisis first emerged.


Source: Bloomberg

Another way to look at stress is with yield spreads between European nations and Germany as Germany is seen as the most credit worthy borrower in Europe. Back in 2011-2012 we saw yield spreads blow out as investors dumped peripheral European sovereign debt and sought the safety of German bunds. Looking at the present situation shows a lack of contagion risk given yield spreads are resting near five-year lows. Note: Portugal and Irish 10-year spreads to Germany are shown on the right axis.

Looking at the USD (top panel) and the Euro (bottom panel) currency swaps also reveal the current level of financial stress is well below levels seen during the 2008 global financial crisis or the 2011 Greek Crisis and US debt ceiling crisis.


Source: Bloomberg

Looking at money markets for signs of stress also shows no contagion risk as money market spreads barely budged today from the news over the weekend.


Source: Bloomberg

So why aren't the credit markets unraveling to signal a financial crisis given how negative the news is? The answer likely lies in the fact that any financial institution that owned Greek sovereign debt back in 2010 has had over five years to sell that debt and remove any financial exposure to the country. Thus, a Greek default carries with it less risk today than it did back in 2010 as mostly large central banks like the International Monetary Fund (NYSE:IMF) or the European Central Bank (ECB) hold Greek debt and have a far greater ability to sustain a hit to their bond portfolio than commercial banks in Europe or other financial institutions like pension funds. This fact is highlighted in the following article:

Stress in Market Plumbing Contained as Greece Firewalls Hold

As Greece shuts its banks and imposes capital controls, stress measures in financial markets show the threat of contagion is limited.

While Greek bank bonds tumbled and a credit-risk benchmark in Europe jumped, indicators of banking stress across the continent and in the U.S. suggest relative calm as concern mounts that Greece will exit the euro. The U.S. two-year interest-rate swap spread, a key measure of risk for banks, rose Monday only to a high matched last week.

The relatively muted effect on markets reflects investors' confidence in firewalls erected to contain the fallout of a potential Greek default during months of debt talks. The European Central Bank has already been buying bonds under its quantitative easing program and has additional crisis tools put in place in the past few years.

"There isn't the immediate knock-on effect for banks across the world as they really don't hold Greek debt," said Peter Tchir, head of macro credit strategy in New York at Brean Capital LLC. "The ECB is going out of its way to support even Greece, and has much more tools and willingness to respond and also support Spain and Italy. So, the contagion risk is far lower."

I will continue to closely monitor the situation with Greece and if financial stress begins to rise materially I will alert readers. Since news agencies can be very sensational and easily work investors into a panic it is important that our investment decisions and outlook be guided by metrics that reliably signal systemic market risk. Currently there is no contagion from Greece but that could change quickly - barring a true financial contagion the worst case scenario is likely a market correction given global economic growth is stabilizing and major economic regions are either undergoing quantitative easing or slashing interest rates and reserve requirements, flooding the global financial markets with a sea of liquidity. As Warren Buffett said, "only when the tide goes out do you see who has been swimming naked." Right now the tide remains.