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?

The Euro continues to trend lower against the Dollar as the recent turmoil in Greece’s government bond markets has started to spread to Portugal and Spain too.  Events are starting to spiral out of control, evidenced by 10-year Greek bond yields rising from below 6% to more than 7% over the past few weeks (inflicting losses on the buyers of Greece’s €8 bln 6.2% 2015 bond which was issued on 25th Jan 2010).

Eight billion euros is only the first instalment on the €53 bln which Greece needs to raise in 2010 and it is this impending refinancing need which will bring matters to a head sooner rather then later.  Greece is now in the market’s spotlight and is really in trouble because this particular bond market storm is not going to simply blow itself out and go away.

The panic in Greece’s bond market is going to have to get a whole lot worse and this will eventually force the rest of the Euro-zone to act.  The markets don’t believe that the Greek government will be able to impose austerity measures on the Greek public (public demonstrations and strikes have already started).  ECB President Trichet has been quoted as saying ”We expect and we are confident that the Greek government will take all the decisions that will permit them to reach their goal”.  What else can he say?  If he told the truth and said they were stuck like pigs in a poke and the squealing would have to get a whole lot louder before they get bailed out, then Greece’s bond market collapse would intensify and yields would rise even more rapidly.

The endgame is fast approaching and it will not include the IMF lending money.  The bigger and more stable members of the Euro cannot allow Greece to be rescued by the IMF and thereby show the whole world that Euro-land can’t manage its own internal affairs.  Whatever tax-raising promises get made by the Greek government are irrelevant (as only time will tell whether they can actually impose the promised tax rises on the Greek public) as Greece does not have the luxury of time on its side.  

The end of this crisis will be signalled by a large amount of money being loaned to Greece by any or all of the following : Germany, France and the ECB.  Watch out for a classic euro-zone “enhanced credit support” fudge whereby the ECB suddenly decides to embark upon Quantitative Easing which involves the purchase of large quantities of euro-zone members’ government bonds.  The EU itself cannot extend a long-term loan because it also represents non-eurozone members.

Markets are going to become even more disorderly before this panic is over but the bigger picture is that this is a panic in the PIIGS’ government bond markets and, whilst it may impact other markets in the short-term, the resolution of the crisis will provide a buying opportunity across multiple asset classes.  The Euro will keep trending lower against the Dollar (and Sterling to a lesser extent) until the crisis is resolved because the resolution may involve the ECB printing a few hundred billion euros.  The ECB will then have joined the other major central banks in the Race to the Bottom and, as usual, the ECB will once again have proved itself to be the slowest to act.

The head of the ECB Jean-Claude Trichet was most insistent during his press conference after the latest ECB meeting that their proposed purchases of €60 bln of “covered bonds” (mostly mortgage-backed securities issued mainly by German banks) did not mean that the ECB was commencing quantitative easing.  His exact words during the Q&A session of the press conference were “we are not at all embarking on Quantitative Easing”. 

Instead the €60 bln covered bond purchase plan was presented as providing “enhanced credit support” to the covered bond market which will help to improve the spreads, depth & liquidity of this particular market, seen by the ECB to be in particular trouble at the moment.

The Bundesbank has clearly dug its heels in over the ECB going down the road of QE and has compromised by agreeing to throw €60 bln instead at the covered bond market.  Good to see the old City adage “If there is a problem then throw money at it until it goes away” has been taken on board by the burghers of Frankfurt.

Meanwhile the Bank of England has taken that particular City adage to heart by expanding its QE program from £75 bln to £125 bln.  And if that does not do the trick then expect the BoE to throw even more money at the problem…there is no shortage of money to spend when the BoE can just print it (even if they describe this printing as “electronically crediting the accounts of those instituitions” which sell securities to the Asset Purchase Facility).  The BoE is aiming to ease the flow of credit throughout the economy by purchasing gilts (mostly).  It hopes the selling institutions will re-invest the proceeds elsewhere, thereby boosting asset prices & tightening credit spreads.  It also hopes that some of this money will leak out into the wider economy and end up as spending on goods & services.  By restricting their buying to gilts, the BoE will be unlikely to lose money as they are financing their purchases at near-zero rates of interest and will likely hold the gilts to maturity.  By spending a big percentage of the Government’s borrowing requirement, the BoE is also hoping its purchases will help to avoid private borrowers being “crowded out” by the deluge of gilts being issued.  Expect the BoE to spend much, much more than £125 bln before its Quantitative Easing program comes to an end.  They truly are going to throw a great deal of money at this problem until it goes away.