By Carmel Crimmins and Nigel Stephenson
LONDON (Reuters) - European stock and bond markets are set to take a sharp hit on Monday after Greece voted 'No' to harsh bailout conditions, and bankers said the European Central Bank's response was now key to the extent of contagion.
Many economists, including those at U.S. banking giant JPMorgan (NYSE:JPM), reckon the outcome of Sunday's referendum will probably hasten Greece's exit from the euro.
"Although the situation is fluid, at this point Greek exit from the euro appears more likely than not," JPMorgan's Malcolm Barr told clients on Sunday evening, adding 'Grexit' was now the bank's "base case".
"'No' most likely means EMU exit," Barclays (LONDON:BARC) told its clients.
As Asia-Pacific currency trading got underway, the euro fell more than 1 percent against the U.S. dollar
While currency weakness in itself won't damage the euro zone economy, the reaction of other southern euro zone government bond markets and the stock markets first thing Monday will be a better measure of the sort of shock that has been largely missing in markets through the weeks and months of the latest standoff.
As recently as Friday, many investors had assumed a 'yes' vote would win out in the end.
ECB NOW CRITICAL
The ECB's decision on whether to continue emergency funding to Greek banks - closed for the past week and enforcing capital controls on deposit withdrawals - will now be critical.
People familiar with the matter told Reuters on Sunday the ECB would continue funding at last week's restrictive levels.
But many banks said the central bank may also have to issue a statement on anti-contagion measures - perhaps holding out the possibility of accelerating or expanding its quantitative easing or bond buying programme in order to calm wider markets.
Earlier on Sunday, ECB Executive Board member Benoit Coeure said the bank was prepared for all outcomes.
"The ECB has been clear that if we need to do more we will do more. We will find the necessary instruments," Coeure said at an economics conference in Aix-en-Provence, southern France.
"Our will to act in this matter should not be doubted."
Sergio Capaldi, fixed income strategist at Italy's Intesa Sanpaolo (MILAN:ISP), said he expected the ECB to try to reassure markets and reduce volatility. "They will show their muscle to the markets."
Capaldi reckoned peripheral bond yield premia over German bunds would widen, with Italy's spread widening by 10-15 basis points to between 150 and 160 bps.
Barclays strategists were gloomier, seeing a move out in Italian spreads to as wide as 200 basis points.
Gary Jenkins, chief credit strategist at ING Capital, said: "Unless there is a pre-market announcement by the ECB I expect the market to be in turmoil."
Euro equity markets too, which had one of their worst weeks of 2015 last week, were set for another selloff.
"The ECB has the capacity to limit the spread of contagion. But we might still see a fall of 3 percent on European markets on Monday," said Antonin Jullier, head of equity trading strategy at Citi.
Asked whether there would be a big market hit come Monday, Mohamed El-Erian, chief economic adviser at Allianz (XETRA:ALVG), said: "Yes, you will see one. With the extent and duration a function of whether the ECB steps in with new anti-contagion measures."
CONTINGENCY PLANNING
European banks went over contingency plans and drafted in extra staff on Sunday, paving the way for large swings when markets open.
Europe's financial firms have been preparing for a possible Greek exit from the euro zone for three years and, having drastically cut their exposure to the country, believe they are well shielded from the fallout from the weekend vote.
"We've been preparing for years and there's nothing more you can do. We just have to see what happens," said one banker from a large euro zone bank.
Foreign exchange traders at Barclays were in the office from Sunday afternoon to follow developments, and research and sales staff were monitoring the Greek referendum over the weekend, a spokesman for the bank said.
Deutsche Bank said it was prepared for any market volatility.
"We have adjusted our processes and procedures to take into account the new situation, which we continue to monitor, ensuring the continuity of business operations and client services," the bank said in an emailed statement.