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Greece on the brink: uncertainty heightens

The break-down in negotiations with its lenders and a surprise call by the government for a referendum on a proposed bailout package has put Greece on the precipice of a collapse.

If the referendum scheduled for next Sunday (July 5, 2015) results in a majority “NO” vote, then Greece will exit the European currency union. Should the outcome result in a “YES” vote, this would indicate that Greeks are willing to accept more austerity measures and could also result in a fall in the government currently in power.

So far, the probability that Greece may have to exit the EMU (European Monetary Union) has only been marginally priced into the markets, but if this becomes a reality, then the exit is likely to be disorderly. According to CIBC World Markets Inc. the events in Greece have led to a “broad acceleration in risk aversion.”

This is expected to lead to a broad-based flight to quality which will likely benefit both US Treasuries and German Bunds, with lower yields in the Bund impacting peripheral spreads and the value of the Euro.

In an effort to stem the negativity, the onus will fall on the European Central Bank (ECB) which will resort to “doing whatever it takes to save the Euro.”

While the ECB does not wish to be involved in the broad political ramifications of the Greek debate – it is expected to continue to maintain the Emergency Liquidity Assistance fund (ELA)in spite doubts about the solvency of the Greek banking system.

In CIBC’s opinion, the markets are expected to focus on a potential discussion of liquidity injections to preclude significant peripheral spread widening. Perversely, the prospect of liquidity injections, while limiting peripheral spread widening, risks adding to broad negativity towards the Euro on the back of a perceived acceleration in the size of the ECB balance sheet.

This would lead to a flight from the Euro. In addition, there is a risk of contagion on periphery rates and sovereign spreads. Corporate credit spreads are also expected to be wider, especially in Europe where corporate credit will be impacted by concerns about the impact on the region’s broad economic fundamentals amidst still fragile growth. In North America spreads are expected to be wider in general, primarily in reaction to lower underlying yields.

Contagion risks and fears over Greek spill-over effects hurting commodity prices and growth assumptions are likely to extend pressure on the Canadian dollar. As well, CIBC believes that the anticipated rise in US rates will likely be pushed out later in the wake of the Greek crisis.

As long as Greece remains on the brink, uncertainty will remain high among global investors.

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