Tuesday, February 1, 2011

Euro Area Woes Edge Toward Spain, Italy

The carnage in Europe’s smaller bond markets is continuing Friday, and the risk is that bigger, stronger economies like Spain and Italy might get infected.

Take a peek at the market for credit-default swaps, which insure investors against the risk of bond defaults. On Friday, the cost to insure Spanish and Italian government bonds against the risk of default suddenly jumped higher, echoing the rising insurance costs for smaller members of the euro bloc like Greece, Ireland and Portugal.

It now costs roughly $246,000 annually to insure $10 million of Spanish debt for five years compared with $235,000 on Thursday, according to data provider Markit. Ireland’s insurance cost jumped gain, to a fifth consecutive record of $610,000, a leap of $28,000 from Thursday evening. And the premium that Spain and Italy would have to pay investors over Germany to borrow from the capital markets has also edged higher.

More pressure on Italy and Spain -– Europe’s third- and fourth-biggest economies -– would signal a worsening of the region’s latest sovereign-debt flare-up. Spain’s central bank reported this morning that growth stalled in the third quarter, which won’t help matters in Madrid.

Since the euro-zone fiscal crisis erupted early this year, investors have narrowed their focus to Ireland, Greece and Portugal, which together make up something like 5% of the 16-nation euro zone’s economy. In other words, they’re minnows of no concern to the overall durability of the euro.

Given that, the euro has recovered from its crisis-driven weakness and is down only 1.4% against the dollar this year. European banking stocks have held up reasonably well. And as my colleague Stephen Fidler points out in a column today, the daily gyrations of credit-default swap prices should be taken with a grain of salt.

But things could get worse, analysts warn. Data provider Markit’s SovX Western Europe index, which tracks investor anxiety about sovereign default, jumped to a record Friday. There’s talk that Russia and Norway’s sovereign wealth funds are souring on Spanish and Irish government bonds. Investors may be a little worried about what will happen if one of Europe’s main “clearing” firms, LCH.Clearnet, hikes up the cost of trading Irish bonds next week, as has been mooted. (A clearer stands between a buyer and seller in a trade, making sure the trade goes through even if one party defaults.)

Lastly, there’s this Sunday’s local elections in Greece. Greek Prime Minister George Papandreou has warned that he’ll call snap elections in December if his party doesn’t do well. One of the things connecting Greece, Ireland and Portugal during this latest credit flare-up has been fears of political turmoil.

So, what’s next? Many analysts are saying the euro can’t possibly stay this resilient against the dollar given the raft of problems licking at its edge. “There is every chance that peripheral Europe weighs on the euro into year-end,” notes Chris Turner, an analyst at ING in London. If the euro does take a major hit, that will probably wake U.S. investors up to Europe’s problems again.

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