Does what happens in Greece stay in Greece? Unless you are playing Greek securities themselves, that's the operative question.
There is really no outcome for Greece itself that worries me. Every troubling scenario starts with contagion to some larger European economy.
The difficulty for anyone trying to trade through this situation is that we just can't know the outcome. Fundamentally, many argue that Greece is well ring-fenced. Unlike 2011, when Greek bonds were widely held by other EU banks, today Greek debt is mostly held by governmental agencies and speculators. The risk of losses on Greek bonds leading directly to financial stress on EU banks is very low.
The danger is actually much more insidious. Say you are in Spain today. You see that Greece has limited withdrawals to 60 euros per day. You're pretty sure your banks are fine, but why not take out a couple thousand euros just in case? Or why not open an account at another country's bank just in case? Other than a minor inconvenience, there is no downside for you.
Of course, if everyone does this then suddenly Spanish banks are in trouble.
Given that the contagion question is essentially a psychological one, guessing the outcome and trying to trade based on that is extremely difficult. You are trying to predict whether an irrational panic will develop, either in traded securities or among depositors. That is impossible to know. In addition, you are betting on how politicians will choose to act, which is sometimes irrational, but, more importantly, always based on non-economic incentives. What is best for Europe or best for investment markets might not be what is best for any given politician's career. I certainly don't want to bet my capital on guessing how the political winds will blow in Greece or Germany.
What I think you can do in these situations is be ready to react to a variety of outcomes. Will illiquidity give you an opportunity to buy good assets on sale? In the bond market, when flows are negative funds become forced sellers into an illiquid market. We saw in 2011 and 2013 huge opportunities in high-yield bonds created by forced selling from ETFs and other funds. We could certainly see the same again.
The situation in Puerto Rico could exacerbate this effect in the muni market. There are a few fund families that have continuously added to Puerto Rican exposure during the last year, believing that the island could work out its problems. Will investors in those funds see huge losses on their June statements? Will that cause big outflows? It is so much easier to create some dry powder by selling high-quality bonds and then be a ready bid when the forced selling comes.
That isn't happening yet. Yesterday the high-yield CDX contract, which is a basket of junk bond CDS contracts, dropped 1 point. That's a big single-day move to be sure. But actual bonds were not really trading, meaning there were no panic sellers. So fast money piled into the CDX because it was the only contract that was trading. But if there isn't any follow-through from cash bonds, those CDX holders will get squeezed out and the contract will rip higher. Here again, I'd rather wait until it is down more, maybe when the RSI shows it as oversold, before doing anything.
As far as rates go, if the European situation turns more dire, it will certainly influence the Fed's decision to hike or not in September. In one sense, September is a long way away. By then, we will have a much more definitive answer about whether Greece is staying in the EU, whether Spanish banks are stable and what the knock-on effect on general economic activity in Europe is. If Greece is contained, the Fed won't have any problem hiking. If U.S. exports are hurting, perhaps because the dollar is soaring, the Fed might wait. Additionally, we might get another situation where German bond yields drop significantly, putting downward pressure on the long end of the U.S. market.
This leaves me mildly bullish on rates here, but I'm mindful that the odds of a September hike should still be more than 50%. If that starts getting priced out entirely, I will likely press a short in 5-year bonds or else trade the fed funds futures contract.
