Greek Bonds Yield Snap Back After EU Bailout Package

As I highlighted on April 23rd, the recent blowout in Greek’s government bond yields presented a good trading opportunity for those investors willing to bet that the EU and IMF would not let their troubled neighbor default on its near-term debt. While the long-term implications from today’s €750 billion bailout remain extremely troubling, the fact of the matter is that France & Germany have been consistently resolute in their commitment to stand by the PIIGS. In engineering one of the biggest short squeezes in modern day history, Europe has sent a clear signal to those pesky hedge funds that they better not consider “attacking” the euro again. Anybody who thought they were bluffing is not feeling so good today.

As indicated in the chart below, Greek two year bond yields have snapped back from 17.3% on Friday to 7.1% this morning. The increase in price from 79.60 of par on Friday to 95.10 today suggests an overnight gain of 20%. Anybody courageous enough to go long Greek bonds last week would be wise to close out their position given the uncertain environment that lies ahead. While the EU’s commitment significantly diminishes the near-term probability of a default, last week’s footage of riots and anarchy suggests the difficultly Greece will have in implementing the austerity measures needed to secure continued EU and IMF funding.

The most important takeaway from the last two years is that governments remain unwilling to let insolvent institutions fail. Whether it is underwater homeowners, overlevered US banks, or profligate European countries, governments have proven time and again that avoiding the consequences of failure usurps the importance of containing moral hazard. It is unfortunate that an investing thesis predicated on “shaking hands with the government” has proven the winning strategy over the last few years. However, the important point is that this can’t go on indefinitely. Governments simply can’t go on assuming the risk of too big to fail banks or countries before investors begin to lose faith in the currencies that underpin these economies (hence my long-term bullish view on gold).

Thee only difference between Greece and California is about 2 years. Just as irresponsible European countries have been able to borrow at artificially low rates thanks to their association with the EU, so too has California been able to borrow in the municipal bond market at rates that severely understate its standalone risks. However, as Greece has shown us last week, there is no rule against sovereign states or nations going bankrupt.

Implicitly, investors must be assuming that the US government would never let its largest state default. However, as the world’s eighth largest economy, California is simply too big for the US to assume its obligations without the dollar/US treasuries coming under severe strain. Investors ought to keep this in the back of their mind as they celebrate the sharp rebound in today’s markets.