MacroScope

So much for Germany being insulated from the euro zone’s troubled periphery. German credit default swaps are already beginning to price in the country’s worst nightmare: that it will have to pay a hefty bill for a deepening euro zone debt crisis.

The cost of insuring 5-year German debt against default rose more than 50 percent over the past month to a record high of 118 basis points.  French CDS rose  around 11 percent over the same period to 189 basis points, according to Markit data. The rise indicates investors are beginning to associate greater risk to holding German debt, even as the triple-A rated bond continues to benefit from safe-haven flows. German Bund futures saw their biggest quarterly rise between July and September since the launch of the euro.

The problem is Germany, the largest sovereign contributor to bailout funds already agreed for Greece, Portugal and Ireland, is expected to pay a high price for any solution to the debt crisis or, given its banks’ high exposure to peripheral debt, for any failure to resolve it.

It could suffer if Greece eventually defaults, as many in markets expect, and if contagion spreads to other peripheral economies. German banks are the second most exposed to Greek and Italian debt and are the biggest holders of Spanish bonds with $177.9 billion in their books, according to data from BIS as at the end of March. Jennifer McKeown, senior European economist at Capital Economics, explains the dilemma:

Developments seem to be edging towards Germany taking on more and more risk relating to peripheral economies. And of course even if there aren’t further bailouts for those economies, Germany’s banks are exposed to the peripheral countries, so they are at risk anyway.

“Inflation is always and everywhere a monetary phenomenon.” That insight of Milton Friedman’s underpins the general perception of a rising money supply as associated with a booming economy. So why, as Europe teeters and the United States struggles, have U.S. monetary aggregates like M1 and M2 been spiking sharply in the last two months? According to Paul Ashworth, chief economist at Capital Economics, it is a knee-jerk reaction to fear, which has driven investors away from European securities and into dollar-denominated deposits:

The surge in M2 over the past couple of months is very similar to the one seen after the collapse of Lehman Brothers three years ago.  … The shift clearly reflects renewed concerns about the health of banks in light of their exposure to euro-zone sovereign debt. In particular, investors are withdrawing their money from accounts at foreign banks.

Greece is in the danger zone. Even as the country’s finance minister sought to reassure his euro zone counterparts at a meeting in Poland, Greek credit default swaps were pricing in a more than 90 percent chance of default, according to Reuters calculations of Markit data. Economists in a Reuters poll see a 65 percent chance of that happening, probably within a year.

Such fears recently sent jitters across financial markets, prompting some words of comfort from German Chancellor Angela Merkel and French President Nicolas Sarkozy that they are determined to keep Greece in the euro zone. But speculation is growing that Greece will default, and that it will be a messy ordeal. Here are some of the potential dangers if it occurs:

* Greece may be seen as setting a precedent for Portugal and Ireland, analysts said. Yields on peripheral euro zone debt could surge rapidly, making funding costs increasingly unsustainable as yields on Italian and Spanish 10-year bonds surge back towards 7 percent. The ECB could have to intervene more aggressively in the secondary bond market to the detriment of its balance sheet.

It’s been a rough week for the euro zone and Italy is feeling the pain.

Despite regular purchases of Italian bonds by the European Central Bank since August — a policy aimed at keeping funding costs affordable — yields on benchmark 10-year Italian government bonds rose as high as 5.6 percent this week. Before the ECB started intervening in the secondary market, yields surged above 6 percent. Beyond 7 percent, funding costs are perceived to be unsustainable.

This raises questions over the effectiveness of ECB policy – doubts heightened  by the shock news that the central bank’s chief economist Juergen Stark would leave the institution early because of disagreements over the bank’s bond-buying policy.

The news highlights the rift inside the central bank over the handling of the worsening debt crisis. It drew a dramatic close  to a week of uncertainty: a debt swap meant to help Greece avoid default hung in balance;  a row over collateral for Greek bailout loans remained unresolved; and national parliaments had yet to ratify increased powers for the euro zone’s rescue fund.

Europe’s debt problems had thus far been largely contained to the so-called periphery, places like Greece, Ireland and Portugal. But increasingly, doubts are rising about countries once seen as insulated — Spain, Italy, even Belgium and France.

Bond markets are not painting a pretty picture. Ten-year Italian and Spanish yields are now firmly trading above 6 percent — 7 percent is considered the point of no return, the level above which funding costs become unsustainable.

The yield gap between 10-year Belgian and German bonds hit a fresh euro life-time high earlier, as did France’s equivalent. Belgium’s 10-year yield spread traded above 200 basis points – lower than around 370 basis points currently on the Italian equivalent but up sharply from readings in the double-digits seen last year.

The second Greek bailout was aimed at ring-fencing euro zone contagion, but could unleash it instead.

Comments from rating agencies since euro zone leaders agreed to involve the private sector in a  Greek rescue plan suggest last week’s events have increased rather than decreased the risk of contagion in the medium-term, says Gary Jenkins of Evolution Securities.

Fitch ratings stated on Friday:

If the Irish and Portuguese economies and public finances are not firmly on a sustainable path going into 2013, when both will need to regain access to medium-term market funding, the potential precedent set by PSI (private-sector involvement) in the Greek package will be incorporated into Fitch’s assessment of the risks to bondholders and reflected in its sovereign rating opinions and actions.

We went behind the scenes of Dubai's debt debacle last November and found a much more sober city-state starting to rebuild itself from the $59 billion hole that was dug by the whizz kids who had powered its transformation. Loans don't come as easy -- particularly the nod and the wink of association with the royal family isn't cutting it like it used to.

Some people see a connection between the crisis and the fact that Dubai has also started to tighten up on its trade with Iran, in line with broader international sanctions, but we're not so sure about that.

What did come across loud and clear in our reporting is that the new-new Dubai is currently being led more by older, senior types who had been thrown off the ladder by the MBAs and the like on their way up. Some of the financial types we spoke to worried about this: we don't need civil engineers, one said, we need financial engineers. It'll be interesting to see how it plays out.

Gary Smith, head of central banks, supranational institutions and sovereign wealth funds at BNP Paribas Investment Partners, has written a special guest blog for Macroscope in which he argues that central banks should consider ways to hedge their FX reserves against the crisis.

“After the 2008 crisis, a mathematical approach to measure the adequate level of foreign exchange reserves – import cover or an equation relating to short-term debt – no longer has much credibility. In the absence of sensible guidelines on adequacy of reserves there is now a general desire to have plenty of reserves.

What is lacking from the reserves debate, however, is whether National Wealth Managers in general (and central bank reserves managers in particular) should invest in assets that might increase in value during a crisis.

It is beginning to look like financial markets cannot handle more than three risks. First we have, as MacroScope reported earlier,  Barclays Wealth worrying about U.S. consumers, euro zone debt and Asian overheating.

Now comes Jim O'Neill and his economic team at Goldman Sachs, with three slightly different notions about risks in the second half, this time in the form of questions. To whit:

1) How deep will the U.S. economic slowdown be and what will  the policy response be? (That's two questions, actually, but let's not nitpick).

The euro zone sovereign debt crisis has not made a near-term collapse of the bloc any more  likely, a survey on hihifrds.com, a website devoted to the Thomson Reuters FX and money markets trading community, suggests.

The survey asked whether all 16 countries currently using the euro would still be doing so by the end of 2012. Fully 88 percent of respondents said they would.

Maybe the 16 euro zone members are tied to the single currency for now but others have more choice. Russian President Dmitry Medvedev and  his Brazilian counterpart Luiz Inacio Lula da Silva have  agreed to consider how to make more use  of their own currencies in bilateral trade, rather than the euro or dollar.