Turmoil Spreads in Europe

Bond Market Selloff Hits Nations Seen as Healthy, Raising Specter of Contagion

Wall Street Journal,

16 November, 2011

Europe's debt troubles on Tuesday spilled over to top-rated nations that had been largely untouched by the crisis—including Austria, the Netherlands, Finland and France—in an ominous sign for European policy makers.

Bond yields across the Continent jumped as prices dropped, in a sign of investors' faltering confidence in officials' ability to keep the debt crisis contained in the euro zone's troubled peripheral countries. Tuesday's selloff came amid news that the euro zone's economy scarcely grew in the third quarter.

Trading of anything but German bunds—seen as safe securities akin to U.S. Treasurys—became difficult. Investors sold bonds issued by triple-A rated France and Austria. Even prices of bonds issued by fiscally upright Northern European triple-A nations such as Finland and the Netherlands fell. Among the cash-strapped periphery, Italian bonds again rose above 7% and Spanish yields surged to 6.358%, according to Tradeweb.

For months, a worst-case scenario of European policy makers has been that the crisis, born in heavily indebted countries, would infect otherwise healthy countries at the heart of the monetary union. Tuesday's trading suggests that could now be happening. If investors go on a buyers strike of European debt, that could raise borrowing costs, and eventually threaten the solvency of much of the euro zone. That could destabilize the global financial system and damage world-wide economic growth.

U.S. Treasury Secretary Timothy Geithner on Tuesday said Europe still hasn't done what is necessary to get beyond the crisis. "They have to figure out a way to get enough political support for what has to happen to try to do it as quickly as possible, so they don't continually fall behind the curve of the market," Mr. Geithner said, speaking at The Wall Street Journal CEO Council in Washington.

Mr. Geithner, choosing his words carefully, suggested the European Central Bank should be doing more. "There are lots of ways for the central bank to play a more effective supportive role…It's not rocket science." He said it was "very hard to get things to work" unless the ECB and European governments work in concert. Mr. Geithner reiterated that the Europeans "will do everything that they need to do" to hold the euro together.

Tuesday's plunge began in Asia and the Middle East, where there was heavy selling of European bonds, market participants said. Of note also, they said, was that much of that was coming from long-term investors such as pension funds and mutual funds, rather than hedge funds.

Then came a weak auction of Spanish treasury bills. As well, the European Union statistics agency Eurostat said gross domestic product in the 17-nation euro zone grew 0.6% at an annualized rate during the third quarter, the weakest expansion since the region came out of a recession more than two years ago.

The dour report showed fewer economies expanding. While Germany and France recovered, Austria barely grew and the Dutch economy contracted.

"I think today is a particularly troubling day for bond markets and the monetary union," said Scott Thiel, head of European and non-U.S. fixed income for BlackRock in London. "I would say we're going through a proper liquidity crisis."

The difference in yields between France and Germany hit 1.89 percentage points Tuesday according to Tradeweb data—near the levels that prevailed in the late 1980s before the creation of the euro. Yields on bonds of the Netherlands rose 0.09 percentage point on Tuesday, rising to 0.626 percentage point above bunds. Finland jumped 0.107 percentage point to 0.707 percentage point above bunds and Austria rose to a spread of 1.80 percentage points.

The growing bond-market jitters come at a time when euro-zone policy makers appear to be running out of options for tackling the currency bloc's crisis. At international summits in late October and early November, European leaders explored ways to beef up their bailout fund for stricken euro members. But they have struggled to find credible ways to do so.

Europe has, for now, put the onus for repairing investor confidence on Italy and Greece, which are installing new, technocrat-led administrations intended to push through unpopular economic reforms. But such moves can take years to bear fruit, and bond markets are increasingly unwilling to fund euro-zone nations with high debts and low economic growth.

The chorus of economists and investors calling for Europe's central bank to intervene much more decisively in bond markets is growing. They say the ECB should adopt the role of lender-of-last-resort to euro-zone governments in order to convince investors it's safe to buy government bonds. But the ECB insists that its mandate is limited to fighting inflation.

Some suggest the ECB could be staying on the sidelines to keep up pressure on politicians, specifically in Italy, to make their economies more competitive and cut their debt loads.

Germany's central bank, the Bundesbank, and the country's economic and political mainstream are vehemently opposed to a more activist ECB, arguing that large-scale bond-buying would fuel inflation and turn the central bank into a plaything of spendthrift Southern European politicians.

The more the crisis of investor confidence spreads into Europe's core economies, however, the less euro-zone governments can do to solve it. Already, France's government is wary of any policy measures that could call its vulnerable triple-A credit rating into question and drive up its borrowing costs.

If the capital flight from bond markets continues, the ECB will increasingly become the only institution in Europe that is capable of stabilizing the situation. A change in thinking in Germany would likely be needed before the ECB embraced a bigger firefighting role, however.

Just last week, European bond markets were rallying on the prospect of new governments in Italy and Greece. News from Italy that Prime Minister Silvio Berlusconi was stepping down was greeted especially warmly by the markets. As the euro zone's third-largest economy, Italy's borrowing needs are considered too big for other European countries to pay for.

But as Mr. Berlusconi's designated successor, former European Commissioner Mario Monti, works to form a government, the market continued its assault on Italian bonds Tuesday, driving yields on 10-year notes up to 7.042%, according to Tradeweb data.

Investors are also paying more for protection against debt defaults. The five-year credit-default swaps of Italy, Spain, France and Belgium all hit records, while the levels for Austria and the Netherlands pushed wider as well. Italian default swaps briefly pierced 600 basis points for the first time.

Few private investors appear willing to step in. As a result, many market participants believe the ECB will ultimately beef up its buying of sovereign debt to support the market and give governments the time to put in place overhauls needed to boost growth and cut debt.