By David Berman
Stocks on Monday are signalling the sober concerns of the European debt crisis, after last week’s euphoria. But the bond market is where the real concerns are being reflected. Paul Krugman pointed out that if Italy were perceived as safe, then its bonds would be trading roughly in line with German government bonds.
And that is not the case: Italian bond yields continued to march higher on Monday, with the five-year bond hitting its highest yield since the euro was introduced and the yield on the 10-year bond rising above 6 per cent. (As bond prices fall, yields rise.)
“The European rescue plan is falling apart even faster than I expected,” Mr. Krugman said on his blog. “[If] the debt must be rolled over at [above] 6 per cent, given the size of Italy’s debt, that vastly increases the primary (non-interest) budget surplus Italy needs to stabilize its position. And that difference is quite plausibly the difference between paying its debts and defaulting. So we’re deep into self-fulfilling pessimism territory here. Either the ECB moves in with big purchases, or the euro is crostini.”
The pessimism follows what had been a nice finish to last week, with stocks rallying amid the best monthly performance for the S&P 500 since 1974. On Monday, though, major indexes took their cues from the bond market, falling sharply and representing a quick shift in attitude among investors. In Europe, Germany’s DAX index fell 2.4 per cent and the U.K.’s FTSE 100 was down 1.7 per cent. In North America, the S&P 500 was down 1.3 per cent in midday trading.
The cracks in the bond market appeared on Friday, when an Italian five-year bond auction resulted in yields of 4.93 per cent, or the highest yield in about 11 years.
Bloomberg News has this good quote from Richard McGuire, senior fixed-income strategist at Rabobank International in London: “Italian bond yields are telling us that the market is not confident that the summit will draw a line under the crisis. They are saying the market still sees scope for bailout contagion and Italy is the next” in line.
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