Greece has been holding the markets hostage

The impact of Greece's financial volatility

Despite all the recent volatility, U.S. markets are stuck in a tight trading range this year, up just 3 percent on the high end, and down 3 percent on the low end. Why is this? Quite simply, because of Greece's precarious financial condition.

On the surface, this makes no sense. Greece only makes up 0.39 percent of the world economy and has a population of just 11 million people. What should really matter are corporate earnings, GDP growth and the direction of interest rates. These data points should be driving the direction of the markets, not a small country in the Mediterranean. The problem is quite simple – the solution is not.

Greece owes $323 billion euros to numerous creditors, the three largest being the International Monetary Fund, the European Union, and Germany. On July 5, the Greek people decided (by an overwhelming 61 percent majority) against accepting further austerity measures demanded by their creditors, which would have amounted to deeper cuts in pension subsidies and higher taxes.

After a serious game of chicken and much back and forth, Greece's creditors have agreed to a third bailout. This means Greece will receive an additional $86 billion euros over the next three years, in exchange for even harsher austerity measures, despite the strong vote by Greeks against austerity. These measures include a higher VAT or value added tax, more budget cuts, and additional reforms to the country's bloated pension system.

This agreement effectively kicks the can down the road for the next three years and gets Greece off the front page for the immediate future. Most importantly, this means Greece avoids going back to their old currency, the drachma, which would have been a financial disaster. Greece's banks have reopened and they are now current on their interest payments to their creditors. Greece just made a $4.2 billion euro payment to the European Central Bank and a $2.05 billion euro payment to the International Monetary Fund.

Why do the markets even care what happens to Greece? The concern stems from the possible domino affect or contagion that could occur if one weak member of the Eurozone leaves, and places the remaining 18 members at risk. If Greece can default on its debt obligations what prevents others who have borrowed a lot of money from doing the exact same thing? When the euro was created in 1999 there was no exit strategy if one member got into financial trouble and wanted to leave. At this point in time, it doesn't appear that this contagion is a real concern, since the debt of other troubled Eurozone members – Portugal, Spain and Italy –  is not priced to reflect the risk of default.

In the short term, this angst about Greece has caused a lot of market volatility but longer term, the markets will discount whatever happens in Greece. Once this happens, investors can get back to analyzing what really matters.

Categories: Economy/Politics, Finance