Separating sentiment from fundamentals

Bond markets have already priced-in Greece’s unsustainable debt load

As Greece is on the verge of exiting the EMU (“Grexit”), Greece’s continued existence in the EMU matters only to the extent to which a Greek default on debt will be orderly or chaotic. In either case, bond markets have already priced-in Greece’s unsustainable debt load, with yields of long-term Greek government debt having entered default territory long before the ECB announced its QE intentions.

The heightened probability of Grexit over the past few days has driven investors to sell off Italian, Spanish and Portuguese bonds whilst piling into safe havens like the German 10Y Bund. However, these moves are likely to be sentiment driven, with the fear of the unknown weighing on the minds of investors over the near term. In reality, the stronger fundamentals in the Eurozone make it highly unlikely that the Eurozone recovery will be derailed by the potential untethering of Greece long term.

In fact, the euro, perhaps the best gauge of sustainable growth within the Eurozone, has remained stable, suggesting that confidence in the Eurozone as a whole has remained unscathed. As also highlighted in the chart below, the euro has hovered around 1.11 to the dollar since February with implied volatility at 13%, unchanged since the start of the year, even with a lack of progress in Greece. As Greece fades from the picture, the strengthening of the Eurozone recovery is likely to be the real pressure point for Eurozone bond markets.

Following the previous macro alert (links can be found here), the bullets below reiterate the view of why both short and long term sentiment in Eurozone’s bond markets is likely to remain downbeat and why bearish positioning may be warranted:

Peripheral European bonds have succumbed to heightened volatility with the imposition of capital controls on Greek banks and no extra funding from the ECB raising the prospect of ‘Grexit’. Sunday’s upcoming referendum is fuelling uncertainty.

1. The souring sentiment in Eurozone bonds is driving a wedge between the yields of the safest safe haven bonds and the Eurozone’s peripheral bonds. Investors are seeking cover in the crowded German Bund while shunning Italian, Spanish and Portuguese government bond
2. Eurozone’s bond market volatility is likely to persist, regardless of the outcome in Greece, with improving economic fundamentals in the rest of the Eurozone economies. The resilient euro serves as the best indicator that confidence in the Eurozone remains intact and contagion risk is limited
3. The banking sector is healthier now than it was a year ago. Bank recapitalization and restructuring, coupled with cheap ECB funding, is encouraging Eurozone banks to depart from government debt hoarding and return to more risk-taking behavior through extending bank credit to households and businesses. This will put the Eurozone’s domestic demand-led recovery on a more solid footing
4. Bearish positioning in Eurozone fixed income may be warranted. Leveraged short ETPs tracking German Bunds and Italian BTPs are efficient investments to play the theme.

Viktor Nossek – Director of Research – WisdomTree Europe