Grexit what if? Greek population prefers a NO

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1 Investment Research General Market Conditions 6 July 2015 Grexit what if? Greek population prefers a NO 61.3% of the Greek population voted No to the Institutions proposal, implying we are now one step closer to a Grexit. We see two scenarios from here and in both cases uncertainty will remain high and dominate for a long time. In the first scenario, we expect a Grexit as there would be a continued harsh stance between Tsipras and the creditors in the coming negotiations about a new deal. However, there is still a likelihood of a political agreement, which in our view could be reached if the current government steps down. A government collapse could follow from increased pressure from the Greek population s dissatisfaction with closed banks and potential payments in IOUs From a political angle, the next steps are uncertain, as no new meetings for negotiation are scheduled. In terms of Greek payments, the next key event is on 20 July, when Greece has to repay the ECB. If Greece does not pay the ECB, it would trigger a broader Greek default and be another step towards a Grexit. In the FI market, we expect Bunds to rally, core curves should flatten, ASW spreads widen and we expect the periphery to widen 20-50bp vs. core on the opening. We recommend clients to stay sidelined in the periphery for now. We expect the EUR to weaken, particularly against safe haven currencies like JPY, CHF and USD. Clients should stay short EUR/USD. EUR/SEK and EUR/DKK should fall slightly while the impact on NOK is mixed given its correlation with oil prices. Expect Scandi FI outperformance as the market prices in further rate cuts and money market curves flatten Greece is one step closer to a Grexit but still some way to go Steps towards a Grexit Negotiations between Greece and the Institutions end in deadlock Greece exits bailout programme as no deal can been reached The ECB caps ELA funding to the Greek banks The Greek government introduces deposit withdrawal limits Greece misses payment to the IMF (falls in arrear) The Greek population vote 'NO' at referendum ECB bond (SMP holding) expires without payment from Greece? The ECB halts ELA funding and/or increases haircuts on collateral? The Greek government runs out of money? The Greek government issues IOU to pay state salaries and pensions? The Greek government introduces 'New Drachma'? Grexit is announced? Recent Research on Grexit Presentation: Greek referendum scenarios and implications Grexit what if? Greek referendum changes the game Presentation: Scenarios for Greece - Summer Crunch Time Grexit What If? Implications for euro and Scandi markets Grexit what if? Don t expect any solution before the summer crunch time Senior Analyst Pernille Bomholdt Henneberg / perni@uk.danskebank.com Chief Analyst Anders Møller Lumholtz andjrg@danskebank.dk Senior Analyst Anders Vestergård Fischer afis@danskebank.dk Chief Analyst, Head of Fixed Income Research Arne Lohmann Rasmussen arr@danskebank.dk Senior Analyst Christin Tuxen tux@danskebank.dk Global Head of FICC Research Thomas Harr thhar@danskebank.dk Important disclosures and certifications are contained from page 9 of this report.

2 Another step towards Grexit The Greek population s No vote in the referendum (No: 61.3%, Yes: 38.7%, participation 62.5%) is yet another step towards a Grexit, and we now believe a Grexit is much more likely. However, there is still some way to go before this event materialises and we believe there will be a long process of high uncertainty about whether Greece will stay in the euro. Although the probability of a political agreement has gone down considerably, we are not yet in Grexit and it should still be possible to reach a new Greek bailout programme, which is required for Greece to remain in the euro. In our view, a way to avoid a Grexit would be a scenario where increased turmoil among the Greek population eventually implies the Greek government would step down. This could result in a new Greek deal, as it would be easier for a new government to reach an agreement with the creditor institutions. From a political perspective, both an Eurogroup and EU leader summit is scheduled Tuesday. And although the Greek leaders have stated the willingness to negotiate immediately, any material progress not likely before EU leaders have discussed the situation after the referendum. Hence, we do not expect positive news about political progress over the coming days. In terms of Greek payments, the next important event is the 20 July, when Greece has to repay EUR3.6bn to the ECB from its SMP holding of Greek government bonds. If Greece does not pay the ECB, it would trigger a broader Greek default and be another step towards a Grexit. First steps towards a Grexit have been taken... but there is still some way to go End-June Greece s bailout extension expired Greece without adjustment programme 14 July: Failure on Samurai bond 20 July: Failure on ECB-held bond Potential trigger of CDS June 28 June 30 June 5 July 6 July??? Tsipras called for referendum (Greek parliament accepted) The ECB capped ELA funding just below EUR90bn Greek government introduce bank holidays and deposit withdrawal limits Greece did not repay debt to the IMF IMF: Greece is now in arrears and can only receive IMF financing once the arrears are cleared. Greek referendum on Institutions proposals Negotiations between Tsipras and Institutions fail No new programme ECB halts ELA funding and/or increases haircuts on collateral Greek government runs out of money and issues IOU to pay state salaries and pensions Greek Central Bank introduces New Drachma Grexit is announced Banks are classified as insolvent and official plans emerge to recapitalise and possibly nationalise them Eurogroup publishes joint statement ECB commits to do whatever it takes Ahead of this, it remains to be seen whether the ECB will remove the ELA funding based on the No vote. Some of the hawkish ECB members, including the Bundesbank s Weidmann, have argued for closing the ELA funding to the Greek banks for weeks, and on Friday, ECB vice President Constancio said a No in the Greek referendum makes it hard to reach a deal and that the Greek bank situation will be weaker if there is a No vote. This suggests that it will be increasingly difficult for the ECB to keep the ELA funding and/or increased haircuts on collateral soon is indeed a possibility. In the meantime, the question is also how long the Greek government can continue without fresh funding. An increased issuance of IOUs to pay state salaries and pensions 2 6 July

3 will add uncertainty to the situation of the Greek population, which has already deteriorated following the introduction of deposit withdrawal limits. Currently, it seems to be a matter of days before deposit withdrawals will be shut as the Greek banking system runs out of cash and it does not seem likely that the ECB allows more liquidity injected through the ELA. The Greek government will soon run out of money 95 EUR bn ECB ELA to Greece February 15 March 15 April 15 May 15 June 15 ELA to Greece (bn EUR) Expiry of ECB bond (SMP holding) crucial deadline 220 EUR bn 210 Household and corporations' deposits with Greek banks Deposits with Greek banks Source: Grexit or government steps down The pressure on Tsipras has never been bigger as he is now confronted with what seems to be an impossible task. Tsipras will approach The Institutions in search of a new and better deal. However, the creditors will most likely reject the proposals the Greek government will put on the table. First, it is very unlikely that the negotiation strategy will result in any concessions from the creditors. Second, the political leaders of Syriza have seemed to be problematic in reaching a deal as they have appeared to be unpredictable during negotiations. The negotiations are set to last for weeks, with banks remaining closed. We see two possible outcomes: Grexit or collapse of government and the path to both scenarios could be similar. As stated above, neither the government nor the Greek people can continue for long (weeks and at most maybe a month) without fresh funding. The Greek finance minister has already overnight mentioned the possibility of issuing IOUs, which is the first step towards introducing a new drachma, implying a full Grexit. This would also enable the Greek government to reopen and recapitalise the banking sector in another currency. However, this would not be in line with the promises given prior to the referendum and not represent the will of the people, as more than 75% of the Greeks are in favour of the staying in the euro, according to recent surveys. In case there is no deal and Greece leaves the euro, we believe the euro leaders will respond strongly. The heads of states and governments are likely to gather and jointly present unity and clearly signal that the coalition could be even stronger without Greece. The risk of who s next should no longer be a real market scare. In the other scenario, the government eventually steps down. This should follow if there is no progress in the negotiations with the creditors as they continue their harsh stance. The domestic pressure from the population would then increase as they run out of cash and get increasingly dissatisfied with the Greek government s issuance of IOUs. 3 6 July

4 The current government would then eventually step down, implying a new government will be formed either after a snap election or as a technocrat or unity government. In either case, it will be easier for the creditors to negotiate with a new government and a new third programme could in this scenario be reached and Greece would stay in the euro. Nevertheless, we are in unchartered territory and it cannot be ruled out that a deal with the current government is reached, although we deem it very unlikely. The arguments for still reaching a deal include: 1) the risk that the short-term financial and economic impact of a Grexit is bigger than expected, and 2) the longer-term risk that Greece recovers and sets a dangerous precedent, as sentiment in Portugal and Spain could turn in favour of leaving the euro next time there is a recession, see Strategy: The end game, 19 June Political path towards a Grexit Snap elections Anti-programme government Pro-programme government Referendum on Institutions proposal (government recommends NO vote) Tsipras steps down Unity government - third party leader Technocrat government New government negotiates with Institutions Creditors reject Creditors accept Greece votes YES Tsipras remains PM Tsipras steps down Greece votes NO Tsipras remains PM Tripras tries to negotiate with Institutions Creditors reject Creditors accept Referendum cancelled Tripras tries to negotiate with Institutions Creditors reject Creditors accept New programme No new programme ECB halts ELA funding Description (bold more likely) Path towards new programme Path towards Grexit ECB removes ELA cap Deposit withdrawal limits gradually removed Grexit very likely Payment to the ECB is next hurdle The next big hurdle for the Greek government is the EUR3.6bn repayment to the ECB due to its SMP holding of Greek government bonds. In contrast to the missed payment to the IMF on 30 June, no payment to the ECB will be seen as a broader default, which would trigger CDS on the Greek government debt as well as rating agencies assigning Greece a default rating. Added to this, if the ECB has not already removed the ELA funding or increased the haircut on collateral, this would follow after a missed payment to the ECB. In this case of 4 6 July

5 a Greek default, the ECB would conclude that Greek banks are no longer solvent and any lending at ECB operations would thus be out of the question, in our view. The Greek government will soon run out of money EUR bn Source: IMF, Bloomberg, Danske Bank Markets IMF payments June (in arrears) * 05 Jun: EUR 0.30bn * 12 Jun: EUR 0.34bn * 16 Jun: EUR 0.57bn * 19 Jun: EUR 0.34bn TOTAL: EUR 1.56bn Jun Jul Aug Sep Oct Nov Dec IMF loan Eurosystem bonds GGB coupons T-bill Expiry of ECB bond (SMP holding) crucial deadline 10-Jul Jul Jul Jul Jul Aug Aug Aug Source: IMF, Bloomberg, Danske Bank Markets 2.0 Samurai bond of EUR85mn is first comming private debt payment Widely viewed that 20 July (GGB payment in SMP portfolio) is the crucial deadline IMF loan Eurosystem bonds JPY bond GGB coupon T-bill EUR bn The ECB backstop facilities are ready Following the announcement of the Greek referendum last weekend, the ECB sent a clear signal of readiness, see statement. Afterwards, a number of prominent ECB members have reiterated the ECB s willingness and readiness to act if needed. In our view, the most likely response would be an increase in the pace of purchases under the QE programme. As with the announcement of the OMT programme, we believe, the signal would be key, together with strong political unity. To what degree the ECB would expand the current size of the QE programme depend on the market reaction to a Grexit. If the contagion were spreading, the ECB could double the monthly QE purchases and target the extra purchases towards the exposed sovereigns until the situation calms down again within weeks, and maybe even faster. The ECB could also use other tools including the OMT programme, which in our view is useful despite its conditionalities. This should follow, as the European Court of Justice has allowed the ECB broad discretion when it prepares and implements an open market operation. Last week, ECB executive board member Benoit Cæuré reiterated the allowance about broad discretion, when he described the instruments at the ECB s disposal. Additionally, the ESM s Secondary Market Support Facility could be used even for countries outside an adjustment programme, but subject to financial market disruptions. For more, see Presentation: Greek referendum scenarios and implications. 5 6 July

6 ECB has a number of back-stop facilities at hand Aim Activated Scope Conditionalities Links * Programme announced in January 2015 * Monthly purchases of EUR60bn (including * Purchases initiated in March 2015 ABSPP and CBPP3) ECB's QE * Address the risks of a too prolonged period of low inflation * Current holdings EUR194bn out of EUR1140bn * Purchases are intended to be carried out until expected at least September 2016 (at least until there is a * Flexibility about pace of purchases (Summer sustained adjustment in inflation) frontloading) Press release ECB's OMT * Defence the singleness of the monetary policy * Programme announced in August 2012 * Purchases never activated * Purchases of sovereign bonds with a maturity of 1-3 years * Conditionalities attached to adjustment programme (direct programme or a precautionary credit line) * Countries issue along the yield curve, to a fairly broad category of investors, and to certain quantities Press release ECB's SMP ESM's Secondary Market Support Facility * Ensure depth and liquidity in market segments which are dysfunctional * Programme annunced in May 2010 * Purchases initiated in May 2010 * Scope determined by the Governing Council * Last purchases in February 2012 * Current holdings EUR134bn down from * Programme terminated in September 2012 EUR220bn in February 2012 * Support the functioning of the * Established in July 2011 government debt markets when the lack of liquidity threatens financial stability * Entered into force in September 2012 * Maximum lending capacity of EUR500bn * Conditionalities attached to adjustment programme Press release * Countries outside adjustment programme, but Guideline subject to financial market disruptions, in a on SMSF sound economic and financial situation (conditions in MoU) ECB's liquidity operations (TLTRO, MRO, USD facility) * Steer short-term interest rates and improve monetary transmission * Regular liquidity-providing transactions * Full allotment * Liquidity obtained against eligible assets mechanism Instruments No to trigger broad based risk-off and prolonged uncertainty The No vote will trigger a broad based risk-off move across asset classes. In the FI market, Bunds should rally, core curves should flatten, ASW spreads widen and we expect the periphery to widen 20-50bp vs core initially on the opening. Market sentiment improved a lot during last week as consensus tilted towards a Yes vote. However, last Monday s price action is likely to tempt some investors to fade any initial move and, hence, we would expect some investors will try to use the re-pricing to scale into risky assets even though uncertainty on what is next is set to prevail for some time. We think the base case in the market now will be that we are moving fast towards Grexit. In terms of the periphery, we are recommending to stay sidelined for now but we do see the current risk off as offering an opportunity to tentatively start scaling in. We no longer consider Greece a systemic risk. Safe-haven currencies like JPY, CHF and to a lesser extent USD would benefit on risk aversion while EUR crosses would weaken. Last week, the initial risk-off reaction was swiftly reversed but we would expect the safe-haven buying to linger for a little longer given that there is now little hope of an orderly solution for Greece. Notably, we think EUR/CHF will be exposed here: even if SNB President Jordan said last week that the SNB had intervened to mitigate CHF strength after the referendum was called and could do so again, we still think it is relatively limited what the SNB can do to go against CHF strength given the central bank s aversion to add to its balance sheet. Whether the sell-off in EUR crosses extend will depend on the policy reaction of the ECB and other central banks. The FOMC has clearly stated its reluctance to start normalising monetary policy at a point in time where the euro area faces heightened uncertainty. As a result, a first Fed hike will likely be postponed as a result of an escalating situation in Greece. This will clearly limit support to USD from a Fed angle and thus reduce 6 6 July

7 downside potential in EUR/USD. With the Bank of England (BoE) likely to largely shadow the Fed in this policy cycle, the same applies to a first BoE hike and GBP. A Greek No should also fuel modest EUR downside versus Scandi currencies. Elevated market volatility may reverse the recent currency outflow from Denmark and Danish rate hikes could be pushed out further. EUR/SEK should also fall, currently trading at the upper end of the range. However, the threat of further action from the Riksbank should protect the downside in EUR/SEK. The impact on the NOK should be more muted but any NOK upside will be reduced by a associated sell-off in oil prices as the European demand outlook deteriorates. As such, Scandi currencies should benefit marginally from the Greek No but local currency appreciation vs. EUR will be mitigated by possible policy responses from Scandi central banks. Overall, investors should maintain short EUR exposures. In our FX Trading Portfolio, we are short EUR/USD and short EUR/NOK. Scandi FI outperformance Last Monday, we published Scandi markets ahead: Spillovers to Scandi markets from Greek crisis. We argued that we could see inflow into the Scandinavian fixed income and currency markets after the referendum was called last Friday. However, these inflows were not seen last week as safe-havens were primarily found in Bunds and the US dollar, and as financial markets seemed to bet on a Yes vote in Greece, the need for safe-havens evaporated fast. However, given the clear message from the Greek voters tonight, we expect a significant risk-off reaction in global financial markets tomorrow. Hence, even though we were wrong last week, we repeat the message on Scandinavia today and expect to see a positive performance for Scandinavian bond markets this week both outright and relative to Bunds. The possible safe-haven flows is of course one argument, but the main argument is that it is still possible to price in more easing (or price out future monetary tightening) in Sweden, Norway and Denmark. Hence, we look for flatter money market curves in Scandinavia in general, and we favour the 5Y segment in the government bond market in Sweden and Norway. In Denmark, the government bond market is characterised by poor liquidity due to the lack of issuance, but here the mortgage bond market is interesting. Last week, we saw the reaction from the Riksbank, where the strong policy move was accompanied by a warning that the Riksbank is ready to do more and is, prepared to intervene on the foreign exchange market if the upturn in inflation is threatened as the result of, for instance, a very problematic development in the markets. Hence, any significant move lower in EUR/SEK will keep the Riksbank alert. In respect of Norway this should strengthen market calls for a rate cut at the September meeting and it is still possible to price in further easing in the Norwegian money market. In Denmark spreads in the government and mortgage bond market are, in our view, attractive in the first place relative to core markets. Furthermore, it is possible to price out independent Danish rate hikes. 7 6 July

8 The news could potentially stop the current currency outflow from Denmark that has been more than DKK100bn over the past three months. A significant part of this outflow has been related to pension funds not rolling over their EUR/DKK hedges, which were established in Q1 when the SNB abandoned the floor below EUR/CHF and investors turned to Denmark. The recent development makes it more likely that EUR/DKK hedges will be rolled over and that domestic investors repatriate funds to the Danish bond markets. If we see a move down to ,4550 in EUR/DKK, the market will conclude that independent Danish rate hikes are far away. 8 6 July

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