Interest Rate Spread Widens As Greece Heads Toward Default

Includes: ERO, EU
by: Daryl Montgomery

Global interest rates continue to diverge, with rates rising in the troubled eurozone countries and falling to new lows in Germany and the United States. The same sort of divergence took place during the 2008 Credit Crisis with yields on safe-haven governments falling markedly, while yields on low-grade corporates soared.

Nowhere in the world is the current interest-rate spread more extreme than in the eurozone (the epicenter of the current credit crisis). Greece is leading the pack with ever-rising yields on its government paper, while German rates keep falling. In Tuesday morning trade, two-year Greek government yields reached a high of 74.88% and ten-year yields a high of 25.01%. Yields on German 10-year bunds were moving in the opposite direction falling as low as 1.679%, even lower than Monday's record-low rate of 1.877% on 10-year U.S. treasuries.

Italy had an auction of 5-year bonds this morning and had to pay a 5.6% yield to get them out the door compared to 4.9% in July. Interest rates on the Italian 10-year were at 5.75%. They were over 6% before the ECB started buying Irish, Portuguese, Spanish and Italian bonds on August 8th to force down surging rates as contagion from Greece spread to other parts of the eurozone. Before that, yields in Ireland had reached approximately 14%, they were over 13% in Portugal, and in Spain they were at similar levels to Italy. Intervention can only maintain below free market rates for so long however. Eventually, the ECB will run out of funds.

The trajectory of Greece's decline toward insolvency is instructive for the future of Ireland, Portugal, Spain and Italy in the near future and for other highly indebted countries such as Japan, the United States and the UK later in the decade. In early 2010, Greek 10-year rates spiked above 12%, but were then driven below 8% with the first bailout. Greece had a debt to GDP ratio around 120%. Severe budget cutting was implemented to hold the debt down. This caused the economy to contract sharply, which lowered tax revenues. Despite the first and now a second bailout, a self-feeding spiral of ever-increasing interest rates began. Higher interest rates and a weakened economy have caused the debt to GDP ratio to reach the 140% level (according to official numbers, estimates are as high as 160%). Rates on credit default swaps now indicate a 98% chance of default.

What the immediate effects of a Greek default will be remain to be seen. There will certainly be damage to the eurozone banking system, which is still in a weakened state from bad loans accumulated before the 2008 Credit Crisis. At some point, the euro will have to be restructured or it will be weakened considerably. Economic damage will not be limited to Europe, but will affect other regions of the globe just as was the case in 2008.

Disclosure: None