Tuesday, 29 May 2012

Is the market mispricing a Greek Euro-exit?

Hardly a day passes without an estimate of the cost of Greece leaving the Euro. Estimates range from few hundred billions up to a trillion Euros. Yet the market seems to be reacting rather cool about it. For many years (2001-2008) markets were pricing a very small premium on peripheral debt. The famous German Put option (Germany would save everyone) ruled the markets. Was the market mispricing the Greek risk then? Is the market mispricing the Greek exit now? The occasional Euro/$ or Bund reaction to Greek polls is predictable and does not indicate imminent collapse of the system. Why? Here are some of the possibilities:

1.    Market is completely mispricing a Greek Euro exit. In other words, they do not believe that it is possible for Greece to leave the Euro. It is just a political poker game and in the end both sides would see sense and back off. 
2.    Markets think that a Greek exit is irrelevant. There are very few Greek bonds traded. Most banks have written down their Greek exposure and any losses would fall on the official sector now. There is no risk of contagion. Greece is a one-off event. Euro would survive.
3.    Markets bet on a huge stimulus response after the Greek exit. In other words, Greece is a goner and the minute it happens the ECB and Europe would step in and save Spain and the rest by allowing Eurobonds, printing, deposit guarantee and fiscal austerity would be a think of the past.
As we live in a quantum world, all possible explanations are valid and all contribute to the current state of trading reaction. However, we believe that (2) & (3) carry more probability weight than (1). In other words, the market is anticipating that a Greek exit would be followed by a flood of money. In fact, many would say that this would be the trigger to save Spain and Italy. Greece would become the sacrificial lamb. Although this view is rather simplistic the history of policy response the past few years lends support to this outcome.
Hence, if there is any mispricing in the market is not about a possible exit from Euro but on the response of the policy makers. If Europe fails to respond then that would be a huge-huge surprise. Similarly, Spain is perfectly capable of exploding and producing another crisis without the help of Greece. Spain does not need Greece. They have enough zombie banks of their own. Even if Greeks decided to wake up tomorrow transformed into Germans, the Spanish problems would not go away.
Greek Polls
New opinion polls came out last Friday indicating that the conservatives were ahead by half a percentage point over SYRIZA, the left coalition. Even though this lead is well into the statistical error area, markets rejoiced. There are many who dismiss many of these polls. They normally accuse them as having equal status to the infamous Greek debt statistics. The truth is that the Greek electorate is extremely volatile and unstable. Let me run you through some of the things I hear:
“I will never vote for ND and PASOK again. They are thieves and traitors”
“I lost my job and have no savings. I will vote for SYRIZA. How much more can I lose?”
“We need a new Papadopoulos (reference to the dead junta leader of 1967)”
“SYRIZA is the only party that stood up to the Germans, the capitalists and the greedy bankers”
“The parties are protecting the civil servants and their interests. The only people who lost their jobs are from private sector. I will vote for SYRIZA so that collapse comes faster.”
“I hate ND but will vote for them this time as I fear Greece might exit the Euro if SYRIZA wins”
“ND and PASOK are scaremongering. Europe and the Germans are scared and are bluffing”
In other words, there is a lot of anger and desperation. Employing logical and rational arguments does not work in this case. Greeks voters are trapped. They feel emancipated having voted for the first time away from the major two parties (ND & PASOK) but find themselves scared of the alternatives available.  They managed to cut off the heads of the main parties but new and uglier heads have sprung out. A bit like the Lernaean Hydra the mythical monster (was Hercules second labor).