Greek contagion still on global risk list

It is hard to believe but only 12 months ago, Greek government bonds were the latest, hottest thing in global finance. A rush of international investor enthusiasm in April 2014 saw Athens swamped with €20bn in orders for an issue of €3bn in five-year debt. Confidence was high that Greece was on the road to recovery, and the bonds were priced to yield less than 5 per cent.

The triumph was fleeting, of course. The turnround in Greece's fortunes since the election of a leftwing, anti-austerity Syriza-led government in January is a reminder of just how badly capital markets can apparently misjudge political risk.

The thought is particularly sobering considering the confidence of many investors that a default by Greece or even its ejection from the eurozone would have limited impact beyond the country itself. What chance that markets will again be badly wrongfooted?

Greece may yet avert a worst-case outcome and has scrambled together sufficient funds to pay bills for a few weeks at least. But the case for arguing "contagion" risks would be limited is that the eurozone is now sufficiently resilient to withstand even "Grexit", or a eurozone exit.

Back in 2012, Greek tensions spread quickly to the bond markets of other countries on the eurozone's "periphery". Since then, however, European governments have assembled bail out funds and Mario Draghi, European Central Bank president, has created policy tools enabling him to combat eurozone "break up" risks.

Eurozone banks are also stronger and the ECB's indicator of cross-market systemic stress, which spiked in 2012, is now lower than before the 2007 global financial crisis. Greek exposures have been identified and contingency plans made; unlike with, say, the collapse of Lehman Brothers in 2008, nobody could argue that Greek default would be a huge surprise.

More crucially, the ECB has launched a €60bn-a-month asset purchase programme that has driven down bond yields across the eurozone. Against that background, confident expectations could become self-fulfilling. "If people believe that systemic risk is not an issue, it will not be an issue," says Richard McGuire, bond strategist at Rabobank.

As a result, specific Greek effects on markets are hard to identity. True, Spanish, Italian and Portuguese 10-year bond yields have risen this month - contrary to the general trend. But that is possibly the result of governments upping issuance.

Correlations between Greek and other peripheral governments' bond yields have broken down since the launch of eurozone QE, according to UniCredit. "The periphery is now relatively immune to pressure on Greece," concluded Luca Cazzulani, UniCredit's deputy head of fixed income strategy. Although the rally in eurozone stocks has lost a little fizz lately, the euro has remained steady against the dollar.

Nevertheless there are signs of rising nervousness. Expectations about euro currency volatility one month ahead have risen strikingly this year. Gauges of expected European stock market volatility have also raced ahead of US equivalents, with levels of divergence similar to those seen at the height of the eurozone debt crisis. The risk is of a sudden swing in sentiment translating in to much bigger actual price moves.

The relative complacency of markets is because investors have mostly assumed, first, that a Greek default or Grexit is unlikely to happen, and second, that if they did, the wider fallout would be manageable. If the first proves wrong, thinking on the second might quickly change.

Grexit would change profoundly the eurozone's character; membership would not longer be seen as irreversible, raising fears that others could follow Greece out the door.

Moreover, the cushion provided by eurozone QE could also disappear. Late in 2011 and early the following year, the ECB also flooded the eurozone financial system with liquidity - then via cheap, long term loans to banks. But that did not prevent the eurozone crisis re-erupting spectacularly by mid-2012.

As the post 2007 crises have subsided, global financial markets have been characterised by sudden spikes in turbulence. Dealers argue regulatory changes have restricted their abilities to make markets, exacerbating price moves at times of stress.

Yield-hunting investors have also often crowded into the same positions, adding to the risk of upsets. Such dangers apply in the case of Greece. It could be the trigger for a future tipping point.

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