The situation with Greece worsened this week, ahead of short-term bond auctions next week. Today Fitch cut Greece’s credit rating two notches from BBB+ to BBB-, the lowest investment grade rating, and maintained a negative outlook. If another downgrade forces the bonds below investment grade, refinancing maturing debt may become impossible.

Greece’s yield curve is massively inverted. With the bill auction coming next week the picture above is very telling. The first part of the Greek curve (in white) is built from indications, so maybe it’s exaggerated, but still. The rest of Greece’s curve is completely flat, signaling that the probability of default is sole determinant of return the market is willing to consider right now. There is no such thing as a term structure of Greek interest rates at this point. This is panic mode. Germany, considered the safest of the Euro countries, is the lowest line in red, and just for fun I threw in Portugal and Spain. It is difficult to see by the graph, but Spain and Portugal have very serious problems of their own. That’s just how much worse the outlook for Greece is.

Greece’s Finance Minister George Papaconstantinou feels that the market’s perception of risk associated with Greece’s sovereign debt is exaggerated. Greece to Germany 10-year spread is currently 396bps. Intraday record is around 440bps, record close is 426bps. Panic mode does not bode well for the 1.6 billion Euro 26-week and 52- week bill auctions set for next Tuesday. Everything is relative when it comes to measuring the success of a bond auction. The market throws a fit when bids for US Treasury bills aren’t over 3.5 times the size of the issue, but some are worried that Greece won’t receive the 1.6 billion Euros in bids it will need to even sell the bonds.

I saw a report this morning that The Bank of Greece is trying to curb short selling of government bonds within its own country by forcing traders to actually cover their positions overnight through repurchase agreements. I had trouble double checking this with other sources but it would be interesting if it was true. I’m not calling Greece’s bond market efficient by any means. But an efficient bond market allows trades to go both ways but the CDS markets are a little different. For every bet on the default of Greece through CDS, there is a bet that they don’t default. A swap is always done with a counterparty. And while for every short seller there is a buyer, liquidity is still bound by the actual float of securities in circulation. More easily put… Greece is afraid of what other problems (basically technical trading problems) can do to an already deadly outlook for funding cost for the country.

Sarkozy and the rest of the EU claim that they stand ready to help if needed, but the austerity measures that are guaranteed to be part of any IMF/EU bailout are at risk of rejection by the people of Greece. Deeply engrained entitlement programs, fed by Socialist policies and plentiful sovereign debt issuance that fueled large deficit spending will be forced out in the terms of any foreign assistance. It is becoming more and more difficult to see how this results in something other than an EU led bailout. An even still, a bailout will likely only begin a long period of pain for the country.

Have a good weekend.

Cliff J. Reynolds Jr., Investment Analyst