Merkel v. Markets

As we think about 2011 there is an undeniable fact that a number of impactful capital market issues remain unresolved. One such ongoing issue is the Greek debt swap deal, the outcome of which would essentially push/pull Greece in to/out of the abyss of a sovereign default. On its surface the negotiation as to the “best” course of action is essentially pitting public and private sector investors against one another over the size of payout to current holders of Greek bonds. However, if we look a little deeper perhaps this negotiation is more fundamental than the overarching complexities lead observers to believe; we submit that ultimately it comes down to whether investors believe that European politicians will prevail, i.e. Germany’s Chancellor Merkel – OR- that capital markets are providing true and accurate information.

Almost daily media outlets like Bloomberg and Reuters report someone close to the talks saying “that the Greek debt swap deal is progressing” or “a deal is imminent”, while Credit Default Swaps (CDS) on Greek debt – essentially insurance purchased by investors in case of a negative Greek credit event/default – still remain at stratospheric levels. Experience tells us that both insider reports and the CDS market cannot be right. Case in point, in October 2011 when European political leaders announced that a Greek debt deal had been agreed to, CDS on Greek debt came down only marginally and for a brief period before reversing course to head even higher, indicating an increased chance of a negative credit event/default. Obviously as of this missive although a deal was announced almost 4 months ago nothing has come to fruition. And again, the financial world nervously awaits an outcome.

While no one can be certain of what will happen leading up to Greece’s March 20th debt repayment, we can say that politicians, like Chancellor Merkel, continue to reassure capital markets participants that a Greek debt swap deal will happen, all while CDS spreads for Greek (and another euro using country - Portugal) continue to indicate that the sovereign debt crisis is far from over.