Europe Not Playing ‘Domino Theory’ Leaves Markets Calm on Greece

It was the selloff that barely happened.

Despite the 61 percent blowout victory for the anti-austerity camp in Sunday’s referendum, financial markets are calm for a second day even as Greece skids toward default and exit from the euro zone.

Italian and Spanish bonds were in demand as Tuesday trading got underway as was the Stoxx Europe 600 Index, defying last week’s forecasts of a rough patch for markets if Greek voters balked at the aid-for-austerity deal.

“Pretty boring,” was how Jens Nordvig, managing director of currency research at Nomura Holdings Inc., viewed the markets in a report to clients on Monday.

Those who read his work regularly shouldn’t have been too surprised by that. For a while now, New York-based Nordvig has been questioning the “domino theory” that posits turmoil in Greece automatically infects other members of the euro-area by raising questions about whether they will have to quit the euro.

“According to this theory, redenomination risk should be positively correlated between all (weak) euro-zone countries and a ‘No’ vote on Sunday would cause immediate and substantial spread widening in peripheral euro-zone countries,” he wrote in a July 2 note. “The problem with this theory is that it may simply be wrong.”

Doubting Wisdom

Among the reasons for doubting the conventional wisdom is the formation since 2010 of a series of firewalls including a permanent bailout fund and the European Central Bank’s bond-buying programs. Investors seem to be betting they will hold strong even as they cut the odds on Greece staying in the single currency bloc.

Nordvig backs up his sanguine view by suggesting the risk of a series of new European currencies hasn’t really increased even as Greece’s crisis has dragged on.

He estimates holders of Greek assets should seek a 409 basis point premium to offset the risk of the drachma returning given the odds of Grexit are about 50 percent. By contrast, he computes the premiums for such a threat for Portugal and Italy to be just 52.3 basis points and 19 basis points respectively.

To Nordvig, “real contagion” will come through politics rather than markets and be transmitted only if non-centrist parties gain further momentum in Italy or Spain. He questions the likelihood of that happening given Greece’s economic pain will make it harder for those forces to rally support.

“Those betting on run-away contagion as a result of Greece getting on an exit path will have to re-think,” he said on Monday. “The so-called domino theory is looking increasingly old fashioned.”