Uncertainty Increases In Greece, But Signs Of Contagion Remain Limited

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Uncertainty Increases In Greece, But Signs Of Contagion Remain Limited by OFR

Developments in Greece, a sharp equity market correction in China, and Puerto Rico’s announcement of a potential debt restructuring have driven risk sentiment in financial markets. The key market focus has been the negotiations between Greece and its official creditors to secure needed government financing. Uncertainty increased significantly in late June, when the Greek government broke off negotiations, called a referendum on the official creditors’ proposal, established capital controls, and missed a payment to the International Monetary Fund (IMF). To date, there have been only moderate spillovers to other euro area periphery markets and safe-haven assets. Developments remain fluid; a more disorderly outcome in Greece than market participants expect may test the stability of broader euro area markets.

Developments since the May report

  • Greece’s negotiations with official creditors broke down; events remain fluid and the outcome uncertain.
  • Puerto Rico’s government signaled a potential restructuring of its debt, triggering a sharp sell-off of its bonds and underperformance of exposed bond insurers. Spillover to the broader municipal debt market was limited.
  • Chinese equities posted a large sell-off, partially reversing their outsized rally and weighing on regional markets and commodities.
  • Long-term advanced economy bond yields rose further in early June, before partially retracing amid uncertainty in Greece and Chinese equity declines.
  • The latest meeting of the Federal Open Market Committee (FOMC) was perceived by market participants asdovish; analysts continue to expect the first interest rate hike to occur in September or December.

Greece broke off negotiations with creditors and introduced capital controls.

Market uncertainty over Greece increasedsignificantly beginning in late June. The Greek government abruptly broke off negotiations with its official creditors to secure needed financing. The government announced a referendum, where Greek voters subsequently rejected the creditors’ latest proposal. The existing Greek financial support program expired on June 30, and the government failed to make a €1.5 billion payment due to the IMF. The European Central Bank (ECB) capped the amount of emergency liquidity assistance (ELA) it provides to Greek banks, increased the haircut on collateral posted by those banks, and stressed that it stands ready to use all instruments to support its mandate. Amid reports of accelerating deposit withdrawals, Greece closed its banks and imposed capital controls in an effort to stem a depletion of bank liquidity. Greek banks are reportedly nearing the limit of financing available from the ECB, meaning that even the limited withdrawals permitted under the current capital controls may be difficult to meet. Following the resignation of the Greek financeminister, the government resumed discussions with its creditors on a new financial support program. The government has a €3.5 billion payment due to the ECB on July 20.


In contrast to the euro area debt crisis in 2010-12, markets have consistently priced in a greater probability of an orderly outcome for the euro area during this episode (Figure 1). Since negotiations broke down, the market reaction has been fairly contained, though the initial price response was significant across some asset classes: core euro area and U.S. sovereign bond yields fell, euro periphery spreads widened, global equities edged lower, and the euro broadly depreciated against major currencies. But overall trading activity was relatively orderly and there have been no signs of aggressive de-risking or significant funding strains. The resilience of euro periphery bonds and broader risk assets was attributed to greater confidence in euro area financial backstops, particularly from the ECB’s asset purchase program, as well as reforms in the euro periphery and a reduction in private sector financial exposures to Greece. A weakening in these points of confidence or a more disorderly outcome in Greece than market participants expect may test the stability of broader euro area markets.


Global long-term bond yields have trended higher since April, reversing months of declines…

Euro area bond yields rose sharply in early June, adding to the unwind of “QE trades” discussed in the May Financial Markets Monitor. The benchmark German 10-year government yield increased more than 90 basis points from its mid-April level of 0.07 percent before partially retracing, partly in response to flight-to-quality flows amid increased uncertainty in Greece (Figure 2). The initial sell-off in early June largely reflected a market correction after an extended rally pushed yields to record lows. Meanwhile, euro area economic activity, inflation, and inflation expectations have continued to improve, diminishing concernsabout a prolonged deflation scenario.


German bonds remained highly volatile in June, with yields trading in their largest intraday range on record (Figure 3). The volatility was attributed partly to the reduction of market liquidity during periods ofstressed trading. As discussed in the 2014 OFR Annual Report, the fragility of liquidity in major bond markets warrants continued close scrutiny, because its amplifying effects could be damaging in the event of a large shock.


Long-term government bond yields in the United States have also risen since mid-April, though with less volatility than in the euro area (Figure 4). As discussed in the April Markets Monitor, strong relative value flows — reflecting trading strategies designed to exploit perceived mispricings or anomalies in global markets — have tightened the links among major long-term bond yields, increasing the correlation among them.

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