Bonds Will Show Whether Firewalls Can Resist Greek Fallout

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To judge how well equipped the euro area is to survive a Greek exit from the currency bloc, look no further than the bond market.

The reaction of Italian, Portuguese and Spanish bonds to a referendum that may decide Greece’s future in the region will gauge investors’ faith in firewalls designed to contain such an event.

In five months of brinkmanship on Greek debt, losses outside of Greece have been relatively muted, as crisis backstops combined with bond purchases under the European Central Bank’s quantitative-easing plan to limit contagion. Earlier in the decade, the government debt of all but the safest euro-zone nations sold off as economic turmoil that started in Greece raised concern the euro area would splinter.

“Peripherals will be under pressure as markets open on Monday as investors anticipate the worst-case scenario for Greece,” said Nick Stamenkovic, a fixed-income strategist at broker RIA Capital Markets Ltd. in Edinburgh. Even so, “the ECB has the firepower to limit damage on other peripheral countries. Indeed the adoption of sovereign QE by the ECB is a game changer, limiting potential upside on peripheral yields.”

What’s Changed?

Although Spanish and Italian bond yields have climbed from record lows as tension in Greece rose, there have been few signs of panic among investors. The biggest daily increase in Spanish 10-year yields in the past two weeks was a 16 basis-point jump on June 15. In 2012, that wouldn’t have been in the top 25 worst days.

The extra yield investors demand to hold Spanish 10-year bonds instead of their German equivalents, a measure of the securities’ risk, narrowed to 119 basis points on Friday, from as much as 176 basis points on June 16. In 2012, when investors feared a Greek exit would spark a domino effect and fracture the euro area, the spread reached 650 basis points.

What’s changed is the construction of a series of firewalls to guard against contagion, starting with ECB President Mario Draghi’s pledge in July 2012 to do whatever it took to save the euro, made the day after the Spanish-German yield spread reached its euro-era high.

European Backstops

Since then, Europe’s policy makers have put in place systems to centralize bank supervision and weaken the link between troubled debtors and taxpayers. A permanent bailout fund, the European Stability Mechanism, was established, succeeding the previous European Financial Stability Facility.

Another prop is coming from the ECB’s purchases of 60 billion euros ($67 billion) of debt each month -- a move intended to stimulate the economy rather than stem contagion -- that helps limit the effect of any selloff in government bonds.

The ECB’s Governing Council agreed on Sunday to freeze the level of emergency aid available to Greek banks.

“The Governing Council is closely monitoring the situation in financial markets and the potential implications for the monetary policy stance and for the balance of risks to price stability in the euro area,” it said in a statement. It’s “determined to use all the instruments available within its mandate,” it said.

The establishment of firewalls has made lawmakers across Europe more confident that a Greek exit from the euro area -- a violation of one of the currency bloc’s key principles -- can be survived without the sort of catastrophe triggered when Lehman Brothers Holdings Inc. collapsed in 2008.

No Lehman

Following the announcement of Greece’s referendum on the conditions international creditors required in return for financial aid, euro-area finance ministers discussed the likelihood of knock-on effects for the rest of the region, according to Ireland’s finance minister Michael Noonan.

“The assessment was that we are in a much better position than we were following the collapse of Lehman Brothers, when Europe was caught unprepared,” he told reporters in Brussels on Saturday. “Since then there is a fiscal union virtually in place. There is a banking union almost completed and in place. EFSF had been established. More importantly also the ESM has been established. There are structural changes and financial buffers on place. So there is no level of anxiety.”

So far, what he says rings true, judging by bond markets. Portuguese securities are still up 1.7 percent year-to-date, according to Bloomberg World Bond Indexes. Italy’s 10-year yield was at 2.15 percent at the end of last week. While that’s up from a record 1.03 percent set on March 12, it compares with a five-year average of 4.18 percent.

Even Greek debt has escaped hideous declines, with the securities down only about 0.4 percent in 2015.

While actions of the ECB and others have helped stem contagion, markets will still react negatively on Monday, Barclays Plc strategists Ajay Rajadhyaksha and Christian Keller wrote in a note on Saturday.

“This announcement should be viewed by markets as an escalation,” the strategists wrote. “Unless something else changes the dynamic significantly over the weekend, the initial reaction by markets on Monday would likely be a flight to quality.”

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