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Prepare for a Greek default

Swap spreads tend to be good leading indicators of systemic risk. Swap spreads started rising in the second half of 2007, for example, fully one year before the 2008 financial crisis hit. So it is troubling to see that european swap spreads have been trending higher in recent months, even as U.S. swap spreads have been relatively low and flat (top chart). Swap spreads in both markets surged last May, when Greece teetered on the verge of default. US spreads settled back down, however, as it became apparent that a sovereign default, if it occurred, would be small potatoes for the huge US economy.

Now Greece is back in the news, as yields on 2-yr Greek government debt have risen to a post-crisis high (second chart). Other PIGS are in trouble as well (Portugal, Ireland, and Spain), but Greek government yields and credit default swaps tower over those of the other countries facing the risk of default. So despite the costly efforts of other Eurozone nations to bail out Greece, the market seems to be saying that a default of some magnitude is unlikely to be avoided. I would brace for that, even though I doubt it would have much of an impact on the global or the US economy. The fact that the euro is only marginally weaker against the dollar in recent months, and European stocks are near their highs, I think confirms that a Greek default won't be an earth-shattering event. With luck, markets have had enough time to price in this grim reality, so when it actually happens the impact won't be too painful.

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