Europe – Now What

In my last two posts I covered what happened in the Greek elections and the potential repercussions of those elections.  Now it’s time to look at what will happen to the EU.  Aside from the previously referenced NYT and Spiegel articles, I used a couple different sources (Krugman, The Big Picture, The Reformed Broker, Kotok) for this post.  My key takeaways are as follows:

• Unless the EU renegotiates its rescue package with Greece, it’s highly likely they will leave the Euro.

• The chances of a renegotiation increased as elections in France and Germany indicate there is a growing backlash against austerity.  Still, Germany seems dead set against a renegotiation and they are the key player.

• Even if the rescue package with Greece is renegotiated, given all the previous aid these appear to be stop gaps that just kick the can down the road

• Thus, unless there is a complete overhaul to the system (e.g. Eurobonds, ECB backstopping banks, etc.) it seems likely Greece will eventually leave even if another new stop gap measure is added.

• Despite the anti-austerity elections there just doesn’t appear to be enough support (e.g. Germany) for an overhaul and the support probably won’t come until Greece leaves and the rest of the EU has to deal with the fallout, which would be…

• Anybody’s guess.  EU leaders appear to have enough resources to weather a Greek exit; however, no country has left the Euro before so it’s really an unknown.

• The real concern is a country like Spain or Italy having massive withdrawals from their banks as markets panic.

• If that happens the ECB will need to backstop the withdrawals and/or institute capital controls, then subsequently guarantee their sovereign bonds and put together some sort of fiscal policy (e.g. Eurobonds).

• Or let the Euro collapse, bringing on an even greater recession to all EU economies simultaneously. 

• Again, the big risk here is not Greece leaving but the potential domino effect that it could create with other EU countries.

• However, the best case scenario is that the elections and a Greek exit are a wakeup call to overhaul the Euro and make it a workable currency.

Greek Elections – The Fallout

In my last post I provided an overview of the Greek elections; now it’s time to look at the Greece faces.  Aside from the previously referenced NYT articles, I used this Spiegel article.  My key takeaways are as follows:

• The parties that initially negotiated the bailout terms are willing to renegotiate some of the bailout terms, but that won’t be enough for Syriza, which is needed for the coalition to have legitimacy.
• As a result new elections will most likely be called with anti-bailout parties primed to pick up more votes.  The new election will basically be a referendum on whether Greece will remain in the Euro.
• Presuming the EU will not finance Greece without the bailout terms, if Greece officially refuses the provisions of the bailout package they will default and leave the Euro, unless the EU relents.  
•  At this point Greece leaving seems likely.  Intrade probability has it around 60% by then end of 2013 for one country to leave the Euro.  That one country would be Greece.
• Assuming that happens, Greece will return to the Drachma.  This will be significantly devalued relative to the Euro, in turn making imports expensive and exports cheaper; thus, making Greece more competitive.  Currency devaluation could be between 50% and 80%.
• It also becomes cheaper to invest in Greece, which would attract FDI (foreign direct investment).
• Private companies with debts denominated in Euros would no longer be able to pay those debts and bankruptcy would then follow.
• Given all that, the IMF estimates a decline in Greece GDP by more than 10% is possible in the first year, but then after that the recovery should be quicker given the devaluation.  
• Such a plan has worked before; however, there is still a risk of a government collapse.  Further, savers essentially have their savings inflated away.
• Note:   Greece is currently in year 5 of their recession.  Unemployment is 22% with youth unemployment at 53%.  In the 3 years unemployment rose by nearly 100%.

 In my final piece on this subject, I will take a prospective look at the fallout in the EU.

Greek Elections – What Happened

Elections were just held in Greece and probably will be held again in June.  Being that I am new to how the Greece Parliamentary system works, I decided to do some digging.  I used some NYT articles (here and here and here) to try and figure out exactly what happened.  My summary is below:

• The two main parties in Greece – New Democracy (center-right) and Socialists – lost seats in Parliamentary elections.
• Syriza (Coalition of Radical Left) and Golden Dawn (far-right) both picked up seats.
• There are now 7 parties in Parliament, which means that a coalition government is going to be very hard to get, and will probably lead to new elections.
• The vote seems to be a clear rejection of the bailout terms; thus, the parties gaining seats are refusing to accept the previous ruling parties negotiated austerity package. 
• Polls indicate that with new elections, parties opposed to the bailout will pick up more seats.
• Further, since Syriza has the second most seats now (16% compared with New Democracy – 20%, and Socialists – 14%) any coalition government formed without them could stoke even more civil unrest.
• The EU’s financial support is dependent on those negotiated austerity measures.  Without those spending cuts, in the absence of a change in policy, the EU will stop financing Greece.
• If the EU pulls the plug Greece will default and be out of the Euro.
• Note:  the EU + international community has pumped in roughly $312B, still debt to GDP is at a peak and the recession worsens.

Next, I will cover what the fallout will be to Greece.

Bonds, Interest Rates, and Risk. Part IV - And Finally, What does it All Mean?

So let’s pull this (1, 2, 3) all together:

1.  It’s unlikely that interest rates will rise given the current environment and the Fed’s position.

2.  Nonetheless it is still possible that interest rates can rise sooner than expected.

3.  If/When interest rates do rise it is unlikely there will be a huge YoY rise:

• Large rises in interest rates tend to happen in bunches and are preceded by smaller jumps
• Large rises happen with higher interest rates and inflation, we have low interest  rates and low inflation

4.  Even if I look at the worst data from all cases and try to estimate the loss, the resulting portfolio capital loss isn’t one of decimation.

• Current duration is 4.85, current interest rates are 1%:  if rates move up 5% this equals a loss of roughly 23%.
• More likely bad scenario (still not likely) is interest rates rise 2.50%: holding the above constant equals a loss of roughly 11% (about the worst it would seem from the data), and doesn’t take into account likely credit spread tightening. 

5.  As a result, worrying about destroying capital because of rising interest rates is probably a misplaced.  Still some losses are very possible and keeping duration within an acceptable range given the current steep curve, low inflationary environment, and low yields is prudent.

6.  Lastly, anything is possible, so have a plan in place if the trend reverses and rates move up quickly.

Bonds, Interest Rates, and Risk. Part III - What Does the Data Show?

As a recap, Part I dealt with bond price movements relative to interest rates.  In Part II I covered the subject of rising interest rates, and presented some data on the 5 Year Treasury, which currently has duration of about 4.85:

• Mean: 0.89
• Standard Deviation: 0.81
• Max: 5.26

So what does this mean to a bond portfolio?  Here are some observations:

• Assuming a normal distribution, in a period of rising interest rates roughly 95% of the time interest rates should not rise by more than 2.50%, meaning the fixed income portfolio value would fall by 12%, exclusive of any interest payments received.  However, I am not sure a normal distribution is completely valid here (see bullet 3).
• The max rise in interest rates is 5.26; however, if purchased a year earlier the bond would have a yield of around 9.50% and a duration (note: higher interest payments = lower duration) of about 3.90.  Thus, the loss that year would have been only about 11%.
• The data appear to cluster together and be prolonged.  By this I mean periods of rising interest rates tend to be trending and thus prolonged.  Further, larger increases in interest rates and smaller increases in interest rates appeared in the same batch (think early 1980’s and high inflation).  In such a data set where observations are at the tails and not around the mean a normal distribution isn’t as useful.  Further, the sample size is probably too small.
• Similarly, the large rises in interest rates came at a period of high inflation and already high interest rates.  Right now we have low inflation and low interest rates.  As such, data from that time period is probably not comparable.
• Most people do not have only Treasury Bonds.  As a result, these calculations ignore credit risk (the risk a bond default), meaning if the aggregate credit risk of your bond portfolio rises then your bond portfolio will have additional losses; however, if it falls your portfolio will have gains.
• With regard to the above, current corporate credit spreads are elevated, but not substantially.  As a result it’s possible credit risk could go either way.  That said it is unlikely that interest rates and credit risk would rise at the same time.  It’s more likely that credit risk would fall as interest rates rise and vice versa (i.e. credit spread narrowing and widening, respectively).

In my next post, the last in the series, I will try and put it all together.