Credibility Issues Weigh on Greek Bonds

Currency in Crisis

Greek bonds continue to be worst performer among European bonds. The 10-year bond yield is up another 10 bp today after a move of roughly the same magnitude at the end of last week.

When the new government under PM Papandreou (elected early Oct) claimed that the deficit it was inheriting was twice what the previous government had projected, there was much hand wringing and disbelief. This weighed on Greek bonds and drew some derisive comments from the rating agencies.

Just before the weekend, Greece reported much weaker than expected Q3 09 GDP figures and downward revisions to past data. In essence the economy contracted by 0.3% in Q3. Economists had forecast flat reading. Q2 GDP was revised to -0.1% from the preliminary estimate of a 0.2% expansion. Q1 GDP was revised to show a 0.5% contraction instead of the 0.3% expansion. Q4 08 was revised to a 0.7% contraction from the initial +0.3% reading. This new data is part of the benchmark revisions going back to 2003.

The data shows a significantly weaker economy than previously was the and shows the contraction has now lasted four consecutive quarters and it is far from clear that a recovery is at hand. Tourism and Greek shipping remain depressed. And the weaker growth profile points to the risk of more fiscal deterioration and this in turn weighs on Greek bonds.

The deficit is the biggest in the euro-zone at more than 12% of GDP this year and forecasts near 13.7% for next year. This would seem to limit the scope for additional fiscal measures to resist or offset the economic contraction.

We had noted before indicative pricing in the credit default swap market implied a greater risk of Greek bonds than Irish bonds, but that the Greek-German bond spreads were narrowed. This is no longer the case as the sell-off in the past two days has pushed Greek bond yields above Irish yields (now by around 9 bp).

Lastly, another aspect of the situation that is troublesome is that Greek banks appeared to heavy users of the ECB 12-month lending facility. Greece's central bank figures suggest that Greece banks accounted for about 42 bln euros of the 570 bln euros of the ECB's long dated operations. The central bank wants the domestic banks to outline potential funding sources as the ECB begins to tighten its liquidity provisions. Early reports suggest Greek banks would consider more covered and conventional bonds and the interbank market (short-term borrowings).

Next month's ECB 12-month provision is expected to be the last, though there is nothing concrete officially yet, just some veiled hints by ECB President Trichet. There is speculation that the ECB will not stop cold turkey nor adopt variable rate repos. Rather most guesses are that the ECB will provide 1 or 2 six month fixed rate operations.

Clearly the news about Greece or the tensions within the euro zone bond market are not sufficient to derail the euro. The $1.50 area is capping it today. Last week's high was $1.5048. Support is seen near $1.4920.