As Greece Nears A Potential "Grexit"

As sad as the Greek situation is, a potential "Grexit" from the eurozone is far in the future. In fact, it is not even a certainty that nonpayment of the IMF's payment of 1.54 billion euros later this month would constitute a default. It also largely depends on how the different creditors and players in this Greek tragedy will interact. For example, it will be up to the European Central Bank (ECB) to decide whether to keep the Bank of Greece liquid. Despite all this, events later this week should give a pretty good indication of the direction in which we can expect things to move in the future.

Since I teach Financial Management, the whole Greek situation serves well to illustrate the relationship between bond prices and yields. It also serves to illustrate a "flight to quality" by investors. Early last week, for example, German sovereign bond yields surged to over 1%, a first in many a moon. Why did the yield increase so much? At that time, it looked like negotiations between Greece and the creditors (the IMF, ECB, and European Commission, among others) were going well, and that an agreement would be reached. Consequently, investors pulled money out of safe German bonds and invested them in something perhaps a little more risky. As a result, German bond prices dropped and yields rose. A similar situation can be observed with Spanish bonds over the last few days; if Greece exits the eurozone, then Spain may be considered to go next. As a result, investors are selling off Spanish bonds, raising their yields. At the same time, investors are flooding back into German bonds, raising their prices and depressing their yields. These actions serve to widen the yield between Spanish and German bonds.