“As demonstrated by the Greek exit (“Grexit”) crisis, however, the situation changes sharply when the market perceives an imminent threat of devaluation (or a withdrawal from the common currency). Spreads then widen throughout the curve, but especially at the shortest maturities, and the curve will almost certainly invert. Why? Because in the event of a devaluation, yields in the devaluing currency will decline sharply (as the currency-risk premium collapses), generating much larger capital gains on longer-term bonds and thereby mitigating more of the currency loss.”
The increase in the yields owing to a devaluation is obvious but could you please elaborate the sequential decrease in the yield curve and the underlying capital gains?
Please provide the pg no and reading no of the core…it has to be read in the context of whatever discussion was taking place there.
So, here’s what could be possible explanation from market perspective –
Whenever, such currency crisis takes place like the one mentioned regarding Greece and market thinks that Greece could exit from EU and currency can decouple from common currency Euro, bond spreads of Greece relative to German Bunds (Bund is a core safe heaven european bond in any risk off scenario) widen especially more in the front end part of the yield curve as crisis is happening now and long end bond spreads don’t widen that much as long end expects that things will normalize in the long run (think of it like VIX curve structure when equity falls sharply) .
Now, coming back to Greece bonds specifically, when a crisis like this emerges its short term bond yields are likely to increase much faster than long term bond yields and so the curve is likely to invert (again like VIX curve structure).
Moreover, the thing about long term bond yield decrease comes from the fact is that since currency will be falling sharply, in this case Euro and there may be a new currency which will take precedence in future like Greece local currency– markets will likely reevaluate its new risk premium as in now Greece bonds will likely be denominated in that new currency and not the original common Euro currency. Hence it will be sort of local currency denominated debt now which may be offset lower risk premium and lower bond yields.
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Thank you sir for the easy explanation.