The 7% Greek Plague


The Bond Vigilantes are going to kill Greece. At the current pace, it probably won’t happen this week, maybe not this month, but it seems like it’s going to happen. A recent post at Abnormal Returns talked about a potential catastrophe for the U.S. resulting from a secular upward trend in long-term yields. However, if such a trend was to take place at a global level, what would happen to our good friends in Greece?

Too bad for the Greeks, but they are sitting between a rock and a hard place.
The Good Scenario

First, we have the general scenario of a sustainable global economic recovery where bond yields would naturally increase. (At the beginning of 2010, most Primary Dealers of U.S. Treasuries were forecasting higher yields.)

Higher inflation, reduced overcapacity, and reduction in unemployment all points to higher yields. If you’re in the more pessimist side, you could also argue that the over-supply of government debt would also add more fire to higher yields (Note: there are numerous other arguments to justify higher yields, actually, too many to list on this post).

The moral of the story for the “economic recovery” path is the following: If investors are going to be paid 4-5% or more to hold U.S. Treasuries, why in the world are they going to hold Greek bonds for the same compensation?

PIMCO, the world’s largest bond fund, reminded us of this fact in a interview with Bloomberg. Here is an excerpt from the article:

“I don’t think that it [7% bond yields] would be an attractive enough yield,” said Clarida today in a Bloomberg Radio interview with Tom Keene. Greece is “sort of like the Titanic. Eighteen things went wrong, and when they go wrong at once it’s problematic,” said Clarida, whose Newport Beach, California-based firm runs the world’s largest mutual fund.

Alright, let’s think about this: PIMCO would not touch Greek bonds even if it came with icing on top. They are not the bond Messiah, but they probably speak for a lot of bond investors. The Greek officials are crying for a 4% yield claiming they won’t be able to sustain payments otherwise. All in all, it seems like a real bailout for Greece is still the only answer to the problem.

Lastly, we have to remember that the potential global recovery that would push yields higher would probably not happen in Greece. As the severe austerity plans take place, what you’re going to see is GDP contraction, social unrest, and a lot of pain.
The Bad Scenario

Now, moving on to the bad scenario: things don’t get better at the global level. The U.S. bond yields will probably do fine because of its safe haven status. However, a little country like Greece is really doomed.

Given the Greek austerity measures, slower global trade,and no global recovery, you have to ask once again why any investor would lend money to Greece at 4-5% ?

Problems are already severe and things will only get worse if the global economy doesn’t resuscitate. The four largest Greek banks are already asking for more financial help (Reuters) and the government is already overspending (EuroInteligence).

So, if the overall macro picture is bad, the weakling (Greece) is definitely toast.
Bad Signs

Back from the future forecasts, the present is showing bad signs. Investors are not just scared of holding longer-term Greek bonds. Short-term Greek bond yields are going through the roof. Here is a screen shot of Greek yields from earlier today:

grece ratges today 2 The 7% Greek Plague

7.27% yield on the one-year? You have to be kidding, otherwise, it’s just plain bad.

The infamous inverted yield curve is starting to play out in the Greek bond world. As most traders know, inverted yield curves are indicators of bad things to come. Additionally, if Greece is having trouble paying 7% on 10-year bonds, they’re definitely going to die if they have to pay those rates for 6-month notes too.

Zero hedge is also speculating that a large bank has sold a Greek bond that matures in about 20 days (link). Rumor or not, given all the other factors at play, it does not send out good vibes.

Overall, the weather forecast looks bad for Greece. Unless, we get a real bailout. But that’s a another story for a different post.

Lastly, you have the Euro. In the post The Big Euro Squeeze, I was recommending not selling the EUR/USD at 1.3300. It rallied to 1.3550 or so in a day or two after the post. At the time of writing, the EUR/USD sits at the 1.3350 level. From a risk-reward perspective, it’s probably not the best place to short. You’re probably going to get positive comments coming from German officials that will rally the Euro. However, as long as there is no real bailout, shorts from the 1.3500-1.3600 area looks very appealing.