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Euro Zone Bond Crisis Grows as Spain’s Problems Deepen

The problems with Spanish sovereign bonds continue to grow, putting greater stress on the entire euro zone, which is already facing the possibility of having to bail out Italy’s E1.9 trillion bond market.

  • David Turner

On Thursday, Spain became the latest European country to edge toward crisis when the yield on its benchmark ten-year bond jumped to a euro-era high following a troubled government auction of debt.

In Thursday trading, yields on Spain’s ten-year bond continued their rapid rise toward the 7 percent mark, which is seen by many investors as the point of no return for government debt. After jumping 30 basis points to reach 6.73 percent, yields looked set to go higher still before the European Central Bank intervened by buying up debt to prevent further damage to prices.

Société Générale summed up the market mood when it said in a Thursday note that “the slow-motion train crash continues” in the euro zone as “contagion spreads more deeply into Spain.”

In earlier stages of the euro zone crisis, yields in Ireland and Greece accelerated rapidly after passing the 7 percent milestone, prompting immediate bailouts.

The higher the yield on bonds, the more unsustainable the interest payments on new debt become, increasing the risk that they will not be paid in full. This realization among fund managers has tended to provoke heavy sell-offs in debt above the 7 percent point.

Until this week cases of what has come to be called euro zone contagion — the syndrome in which fears about a country’s debt take root in another country, whose sovereigns were previously considered safe — had looked severe in only a small number of member states.

However, in recent days yields for a wide range of euro zone sovereigns have soared. Despite the ECB’s intervention, Spanish ten-year bond yields closed at 6.54 percent on Thursday — up 11 basis points on the day and 70 points higher than last week’s close. French yields are 20 basis points higher so far this week on continuing fears that the country’s triple-A credit rating may be downgraded, and Belgium’s are up 40 basis points, to 4.92 percent. Even in the Netherlands, seen as one of the strongest euro zone economies, yields have risen 20 basis points, to 2.51 percent.

Euro zone contagion is spreading partly because investors realize that even when the ECB steps in with emergency buying to support member states’ bonds, its efforts are only partly successful. Italian ten-year bonds closed just below the crucial 7 percent mark, at 6.86 percent, on Thursday because of ECB buying, but 6.86 percent is not an affordable long-term rate for Italy. In any case, Mario Draghi, the ECB’s new president, has made clear that he sees the central bank’s bond purchases for troubled countries such as Italy and Spain as only a temporary measure. Early this month, on his third day in office, Draghi told journalists, “It’s really pointless to think that sovereign bond rates could stably be brought down for a prolonged period of time by outside, external interventions.”

The contagion is also growing because investors realize that as the number of euro zone member states with distressed sovereign markets continues to grow, the ability of the region as a whole to as a whole to support individual countries weakens. The European Financial Stability Facility, the euro zone’s rescue fund, does not currently have the resources to bail out Italy’s E1.9 trillion ($2.56 trillion) bond market, let alone those of France, Spain and Belgium.

Spain is suffering from particularly deep investor scepticism that it will be able to shrink its high fiscal deficit — estimated by UBS to be more than 7 percent of GDP — without provoking a deep recession in its already stagnant economy. Tuesday numbers from Eurostat, the European Union statistical agency, showed that Spain’s economy failed to grow in the third quarter. If this worsened into an outright decline in output, tax revenues would plummet, making it even harder for the Spanish government to meet its debt interest payments.

The latest polls point to a victory in Spain’s general election on Sunday by the opposition, center-right Popular Party, which has pledged to continue the country’s fiscal retrenchment.

Thursday’s rise in Spanish yields was triggered when the country’s government managed to sell only E3.56 billion in ten-year bonds out of a target of E4 billion — and, at 6.975 percent, more than 150 basis points higher than last month’s auction.

The FTSEurofirst 300 Index of euro zone stocks fell 1.3 percent, to 957.85, on Thursday on further concerns that the euro zone debt crisis is badly damaging businesses’ earnings. A net 30 percent of European fund managers are underweight in euro zone equities, with a net 72 percent expecting a recession in Europe in the coming 12 months, according to a Tuesday survey by Bank of America Merrill Lynch.