Contagion strikes Europe’s core

November 23, 2011

Any lingering illusion that the European crisis could be contained to so-called peripheral countries with high debt levels was shattered on Wednesday. German government bonds, which had thus far been seen as a safe-haven, slumped sharply after investors shunned the country’s auction of new 10-year debt.

Germany drew significantly less bids than the amount on offer for its Bunds, with investors deterred by very low yields. There is a growing view the euro zone powerhouse will pay a high price whatever the outcome of the regional debt crisis. If the crisis spirals out of control, some fear that it could reach a magnitude that would hit Germany as well by sending it into a deep recession. On the other hand, any solution to the crisis is likely to involve a higher fiscal bill for Germany.

Marc Ostwald at Monument Securities in London describe the auction as “a complete and utter disaster.” He continued:

If Germany can only manage a 0.65 cover in actual terms for what is going to be their next benchmark then what hope for everybody else?

Bund futures settled down 144 ticks on the day at 135.81. Ten-year German bond yields jumped 14.5 basis points to 2.056 percent, yielding more than U.S. Treasury notes for the first time since early October.

UK Gilts were also outperforming Bunds, with the yield premium for holding 10-year British bonds narrowing to its tightest since mid-2009 to 8.5 basis points. l “It should be a wake-up call to the euro zone policymakers,” Phillip Shaw, chief economist at Investec said.

Belgium, too, came under renewed pressure. The risk premium demanded by investors to hold Belgian government debt compared with benchmark German Bunds hit a euro era high on Wednesday, reflecting growing concern about the country’s failure to agree on a budget for next year. Belgian 10-year government bond yields soared 41 basis points on the day to 5.51 percent, pushing the spread over German benchmarks to a euro-era high of over 340 basis points.

Ten-year French bond yields were up 14 basis points at 3.67 percent, and Fitch credit rating agency said France would have limited room to absorb any new shocks to its public finances without endangering its AAA status.

With Germany under the gun, it remains to be seen whether the country’s leadership warms up to a broader bailout from the European Central Bank. For now, the saga continues, with no clear end in sight.

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