As widely expected, the latest meeting of euro-area finance ministers—the Euro-group—ended without an agreement between Greece and its official creditors. The mood of the subsequent press conference was somber, and hopes of a deal to avoid Greece defaulting on a payment to the International Monetary Fund (IMF) on June 30 are fading fast. Indeed, the head of the Eurogroup said that the disbursement of funds before the end of the month is now “unthinkable”.

That doesn’t quite mean Greece has reached the end of the road. As German Chancellor Angela Merkel said recently, “where there’s a will there’s a way”. If an agreement can be reached at an emergency European Union (EU) summit next Monday, there are still ways to avoid an immediate bankruptcy. But, for that to happen, Greece will have to make new concessions and, despite the high stakes involved, has given no indication that it’s willing to do so. Without Greek concessions, Monday’s summit might be as much about contingency planning as trying to avoid a default.

There are various interpretations of the Greek government’s negotiating strategy.

One is that it wants to take the negotiations down to the wire in the hope that its euro-area partners will “blink” and that it will be able to secure the best deal available (i.e. one that includes up-front debt relief). The other possibility, and one that we have long feared, is that the gaps between the two sides are simply too big to bridge.

It’s hard to know which of these interpretations is correct. Based on developments so far, there are few grounds for optimism. But we also recognize that both sides have a lot to lose and that the EU has a long history of flexible deadlines and last-minute compromises. One thing does seem clear, though. Unless euro-area leaders are willing to overrule their finance ministers (and risk losing the IMF’s involvement in the process), the main concessions will have to come from Greece.

Point of no return?

So what happens if Greece’s euro-area partners don’t blink and the Greek government doesn’t back down?

In our view, it’s then reasonable to assume that Greece will default on the IMF at the end of the month and exit its international bailout at the same time (thus losing potential access to €18 billion of undisbursed funding). It’s also difficult to see where the government would find the funds to redeem a €3.5 billion bond, held by the European Central Bank (ECB), on July 20.

In recent months, the ECB has single-handedly kept the Greek banking system afloat in the face of huge deposit outflows (Displays 1 and 2). It has done so by providing the banks with enormous amounts of emergency liquidity assistance, or ELA (Display 3). In our view, this will no longer be possible if Greece defaults on the IMF. Capital controls would surely follow (if they’re not imposed before then to stem accelerating deposit/capital flight).

This would be a catastrophic scenario for the Greek economy, which would be plunged into an even deeper recession, pushing the public finances further off course. It would not necessarily lead to Greece leaving the euro—most Greeks are in favor of the single currency, though not the reforms that come with it—but it would clearly represent a step in that direction.

The post Greece reaches the Last-Chance Saloon appeared first on AdviserVoice.

Euro-area bond yields have soared in recent weeks, with the German 10-year yield rising by 100 basis points from a low of 0.05% in the middle of April to over 1.0% at one point this week. This huge adjustment takes yields back to September 2014 levels (Display 1), long before the European Central Bank (ECB) launched its quantitative easing (QE) program. It’s also the biggest increase in bund yields over an eight-week period since the reunification boom in the early 1990s.

ECB unruffled

Perhaps surprisingly, the ECB has not been unduly ruffled by these developments. There are several reasons for this, in our view.

First, the ECB probably regards much of the recent sell-off as a correction from unsustainable levels—the result of what president Mario Draghi recently called “one directional investments”. In this respect, it’s worth noting that, before their recent rise, German yields had fallen to levels never seen at any stage in Japan over the past 20 years—despite the latter experiencing persistent deflation and negative nominal GDP growth, neither of which are present in the euro area.

Second, as noted by several ECB Council members, higher bond yields may reflect improved prospects for economic growth and inflation in the euro area—in other words, rising yields may be a sign that the ECB’s policies are working.

Third, unlike in other countries, QE in the euro area is not primarily about reducing long-term bond yields (which were already at record lows long before the launch of the program). Rather, it’s about underpinning inflation expectations and underscoring the ECB’s commitment to do “whatever it takes” to prevent the euro area slipping into deflation. If the ECB is successful, bund yields ought to rise—especially given their low starting point.

Inflation expectations start to rise

So is this what’s happened recently? We think the answer is a qualified yes. When the ECB laid the groundwork for QE last year, it attached considerable importance to declining market-based measures of medium-term inflation expectations. As Display 2 shows, these measures have started to rise again—though not back to levels consistent with the ECB’s definition of price stability, nor by as much as the rise in bond yields (a point we’ll return to).

And deflation risks start to recede

In addition, our own analysis suggests that deflation risk is starting to recede in the euro area. We can illustrate this using our deflation risk indicator (DRI)*, which peaked in the third quarter of last year but has since fallen back (Display 3).

It’s important to note that the DRI is a broad-based guide to deflation risk and that the recent improvement is not related to higher consumer price inflation (which is still lower than in the third quarter of last year). Rather, the improvement has been driven by the DRI components that are most sensitive to monetary policy: asset prices, the exchange rate, money-supply growth and the size of the ECB’s balance sheet.

Tighter financial conditions

But while rising inflation expectations and diminishing deflation risk may explain part of the recent surge in bond yields, a note of caution is necessary. As noted earlier, the increase in inflation expectations has not kept pace with the rise in bond yields, especially in more recent weeks. And this has led to higher real yields (Display 4) and de facto tightening of financial conditions.

Like the ECB, we are not yet too worried about the recent rise in bond yields. But one of the key factors underpinning our positive view on the euro-area outlook is the improvement in monetary conditions that has taken place over the last year. A premature tightening of financial conditions is not part of the script and needs to be closely monitored. Despite its calm reaction to recent market developments, the ECB is likely to have similar concerns. Its tolerance for yet higher bond yields is therefore likely to be limited, in our view.*

*The deflation risk indicator includes the following variables: three measures of inflation, the level and change in the output gap, economic growth relative to previous trend, the level and change in asset prices (equities and housing), change in the nominal exchange rate, level of the real exchange rate, bank-lending growth, money-supply growth, real interest rates and the size of the central bank’s balance sheet. See Deflation in the Euro Area: Are We There Yet? November 20, 2014 for further details.

The post Will bond markets turn too fast and furious for the ECB? appeared first on AdviserVoice.