Its never over until the fat lady sings.

Greece still has to raise over 10 bln euros during April & May and the world’s bond investors know this only too well.

There is no point in them aggressively bidding up Greek debt and tightening its spread over German bunds whilst there is still an avalanche of supply to be absorbed.  The core problem with the EU & IMF agreeing to lend Greece money at Greek market interest rates if Greece fails to find willing buyers for her debt is that the EU/IMF proposal provides no incentive for the market to tighten Greece’s spreads over bunds (Greek 10-year bond yields traded above 7% in this first week of April 2010).   However during yesterday’s ECB press conference, Jean-Claude Trichet moved the goalposts and implied that “market interest rates” did not mean the cost of borrowing to Greece but the cost to each individual euro-zone member of raising their share of the money that would be lent to Greece.  If this is true then you can expect Greece to try to borrow money (effectively at a weighted average euro-area interest rate) from her fellow euro-zone members as soon as possible, i.e. this weekend.

In the absence of cheaper loans from fellow euro-zone members, it will only be when the markets sense that Greece has got over the crest of the hill (in terms of satisfying its funding requirements for 2010) that spreads over bunds will then start to tighten. In the meantime each week’s trading in Greek bonds is likely to follow the same pattern – big sell-off on Monday morning if there has been no bailout over the weekend then spreads squeeze tighter towards the end of the week in case a bailout emerges over the following weekend.

The EU and IMF are imminently going to be called upon by Greece to show the colour (and price!) of their money.  If & when the euro-zone members do get their act together, then the ending of the current uncertainty will cause a rally in the euro currency (and Greek debt spreads will snap tighter too).  It will all be announced over a weekend before the markets reopen on the Monday morning.

Its not over until the fat lady sings and Greece’s fat lady is currently warming up her voice in the wings and is about to step onto the stage.

Another EU summit passes by and still Greece has yet to get any joy from its fellow euro-zone members.  All Greece has been offered is a combination of loans from euro-zone members combined with loans from the IMF at market interest rates.  That is not what friends are for – they are supposed to lend you money cheaply when you are in a pickle.

Greece quite correctly points out that it is effectively adopting an IMF-style austerity program but without access to long-term loans at usual IMF-style interest rates of roughly 3.25%.  Instead Greece is having to pay more than 6% to borrow long-term money from government bond investors. Understandably Greece is not happy about this state of affairs.  Unfortunately the normal “3-pronged IMF cure” of a cheap loan, big devaluation and budget cuts will not work for Greece because Greece is locked into the Euro and cannot stimulate its economy to grow by devaluing its currency since the Drachma no longer exists.

The rest of the euro-zone cannot allow Greece to leave the Euro and revert to the Drachma (which would promptly collapse against the Euro).  This is because every euro-zone bank which owns Greek debt would suffer large losses on their Greek bonds.  The rest of Europe’s peripheral bond markets would also crater as investors headed for the safety of German bunds, so banks would also suffer losses on their other euro-zone debt assets which would precipitate another banking crisis in Europe. Bank runs would also take place in the weaker countries as savers moved deposits to banks located in core euro-zone countries. 

The ECB has also been forced to relax its collateral criteria so as to allow Greek government bonds to be eligible even if Greece has its credit rating downgraded in the future.  In the good old days the ECB would only lend against bonds rated A- or better but during the credit crunch the ECB decided to accept bonds rated as low as BBB-.  The ECB had planned to tighten the criteria back up at the end of 2010 but yesterday ECB President Jean-Claude Trichet confirmed that the ECB would carry on accepting BBB- bonds “beyond the end of 2010″.  It is notable that this commitment is deliberately open-ended.

The broader question is starting to arise :  Just what is the point of the Euro?

It serves Germany because the countries she exports to can no longer devalue their currencies to gain a competitive advantage.  However, as the current Greek crisis is now illustrating, when a euro-member country gets into trouble there are no benefits to euro-membership.  The markets charge you a hefty premium to borrow money and you can’t even get a cheap loan from your euro-mates to tide you over.  And you can’t devalue your currency to gain some relief either.  And you get lectured by your biggest sister that you wouldn’t be in such a mess if you had played by the rules all along.  Not much help when you are stuck.  Not much help either are the Growth & Stability Pact rules that say you get fined just when you are least able to pay (although no-one has yet been forced to pay).

The biggest draw of the Euro to aspiring members was the hope that everyone would be able to borrow at close to the interest rates that Germany borrows at.  This hope has now come seriously unstuck and needs patching back together again.  What is the point of joining a club which offers no benefits to members?

Over the past few weeks the Euro has formed a triple bottom at 1.3450 against the Dollar (the lows were on 19 Feb, 25 Feb and 2 Mar 2010).  Triple bottoms are rare in markets because most times a market prints a bottom, bounces off that bottom the first time it is tested but breaks through the support level if it is tested again (hence the old trading adage “Fade the first test but Go With the second test”).

The Euro now appears to have absorbed the selling pressure which has resulted from the problems Greece has been having in refinancing its borrowings.  Whilst the EU has pledged not to abandon Greece it has still not given any firm details on how it plans to offer support to Greece other than to encourage Greece to reduce its budget deficit towards 3% of GDP (as per the euro-zone’s Growth & Stability Pact).  Greece for its part “would like to borrow on the same terms” as other euro-zone members.  However the bond markets will demand a substantial premium to lend money to Greece until it proves it is actually carrying out the deficit-reduction measures it has promised in recent weeks. Yesterday Greece sold a €5 bln 10-year bond with a coupon of 6.25%, yielding roughly 312 bps over Bunds.

It has also become clearer over recent weeks that any support extended to Greece by the EU will not formally involve the ECB printing any money.  Euro-zone member governments have met public opposition to bailing out Greece with taxpayers’ money and the German press in particular has run stories opposing bailing out Greece if it means Greek public sector workers can still retire earlier than their German equivalents or even suggesting Greece sell off some of its uninhabited islands to raise some money.  Greece has in turn demanded the Germans return Greek gold which the Nazis allegedly stole during World War II…

Back to reality.  The receding prospect of the ECB printing money has helped the Euro to find support over recent weeks.  There is a subtle difference between the ECB printing money in order to buy Greek bonds and other euro-zone banks buying Greek bonds yielding circa 6% (with a strong nudge and guarantees from their respective governments) which they then use as collateral to borrow money from the ECB (at 1%).  The latter is simply good banking even if the net effect either way is the ECB finances loaning Greece money.  In the latter case the ECB can correctly claim that the risk lies not with it but with the banks.

Now that the Euro has found support at 1.3450 (until the market proves us wrong), the forex market can switch its attention to giving the Pound Sterling a good kicking in the run up to the May General Election.

German Chancellor Angela Merkel has extracted the necessary promises from Greece that they will be good in future and properly respect the rules of the euro-zone’s Growth & Stability Pact (i.e. bring their budget deficit back down to less than 3% of GDP).  Whilst the bigger & stronger countries within the euro haven’t quite worked out all the details yet, Germany has sent a “clear political signal” to Greece and the wider financial markets that (with the independent IMF checking that Greece keeps to its promises) they will support Greece if it cannot borrow enough money at a reasonable rate from government bond investors.

This is a pivotal moment in the course of the euro-zone and its monetary union.  Germany is the key player and can make-or-break any smaller country which gets into trouble raising money from government bond investors.  Bringing in an independent outside entity, such as the IMF, to play policeman will allow countries to sell difficult tax-raising budgets to their voters.  Having given up the Drachma for the Euro, Greece no longer has a central bank which can print money to finance its deficit and/or devalue its currency (both of which are exactly what the UK has done over the last year or so).

An important precedent has thus been set and Germany has used this Greek crisis to get what it wants, namely the peripheral nations are going to have to play by the rules from now on or they will get hung out to dry. This is going to be tough on the economies of the peripheral countries and their growth is going to suffer as they shrink their budget deficits back down from 10%+ to below 3% of GDP over the next 3 to 5 years. 

However the message to players in the government bond markets is clear – the great convergence trade (which last took place in the run-up to the euro’s birth on 1st Jan 1999) is now back on.  Spreads over bunds have now tacked back onto a tightening trend and, whilst they will not converge all the way down to 20bps or so, it is going to be worthwhile buying the dips every time the yield spreads over bunds widen back out again.