Markets are early on their Greek-exit trade

by Jay Pestrichelli on May 17th, 2012

The market has already taken steps as if a Greek exit is unavoidable. I’m not saying it happens, but the market has already begun its preparations for it.

If Greece reverts back to the drachma, the new/old currency will most likely be pegged to the Euro. There are many currencies today in European nations that are not in the Euro, but peg their local currency conversion to the euro. You can think about them as Euro wanna-be currencies. They get the benefits of stability that the Euro provides, but avoid the issues of getting 17 nations sticking their hands in monetary policy. So being on the drachma isn’t really a big deal.

However, the conversion to a pegged drachma will be ugly. Most likely a broad default on its debt will occur and massive devaluation ends up being the only way out. This results in printing a lot more drachmas, inflation and the worst of all, a lack of trust in newly issued debt that will keep Greek interest rates high. Not so much because they defaulted, but because they are in the midst of a depression with shrinking GDP and unemployment around 21%.

The first and largest hurdle to the exit is to figure out if it is even legal. As there are no stipulations that allow for an exit, legislation will need to be drafted and passed. Can all this actually happen in a timely manner? Most likely not considering Greece is having trouble even putting together a government.

Despite the time challenge, the markets have reacted in two ways so far. First, the flight to safety has already begun and that means US Treasuries are getting bid up. The 10-year and 30-year bonds have run up to new highs sending interest rates to new lows; Chairman Bernanke must be pleased with that aspect of this.

The second reaction is a stronger dollar. Not just against the Euro, but against all currencies. This has driven commodity prices and currency ETFs, like FXE, to low levels not seen in months. Even gold that is normally considered a safe haven in the face of inflation is feeling the pressure of the currency exchange.

Both of these trades are justified, but probably too early. This process will take months and if you haven’t participated yet in either of these moves, don’t worry. You’ll get another chance as the early movers will get tired of their investments sitting idle for months of European leaders debating how to execute the exit.

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