Why Markets Are Underplaying Greek Drama

Europe could be facing a Lehman moment, the European Central Bank has warned. Yet the credit markets seem to be intent on enjoying a Chuck Prince moment, obeying the former Citigroup boss's dictum that "as long as the music is playing, you've got to get up and dance." How else to explain the continuing disconnect between roaring risk appetite and the threat posed by a possible Greek bond restructuring?
Greek bonds trade at levels that reflect the market's view that a substantial restructuring is inevitable. Underlining what is at stake, the ECB has warned that any move to "re-profile" Greek debt by extending maturities would constitute a credit event, making the bonds ineligible as collateral for borrowing under ECB rules. Yet other parts of the bond market appear unconcerned. The cost of insuring corporate debt has remained low, and Europe's high-yield bond market is on a tear, with issuance running at a record pace.
In mid-2007, Mr. Prince's confidence reflected a belief that there was enough liquidity in the system to deal with a shock from the U.S. subprime mortgage market. That both overestimated the persistence of liquidity and underestimated the linkages between different parts of the financial markets.
Policy makers and markets may be making the same miscalculation today. Liquidity is a key driver of credit markets again, although it is now provided by the public rather than private sector. Central banks have reduced the return on cash to zero, driving a search for yield. Markets have an inbuilt momentum: investors who take defensive positions fearing a Greek debt restructuring will underperform if a restructuring does not occur.
As a result, markets ignore second-round effects until they can no longer do so. Prices for Greek bonds suggest a restructuring is "priced in" and need not be a shock. But contagion effects are unpredictable. The banking system remains vulnerable to the sovereign crisis.
The music is still playing. But European politicians seeking a Greek debt restructuring shouldn't be lulled by the lack of reaction in markets to their discussions. The crowded dance floor could empty quickly.