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Spreads in Europe on Track to Test Pre-Bailout Levels

June 7th, 2010 Michael McDonough

The aggregated spreads of Europe’s weakest peripheries plus Belgium are on track to test their pre-bailout levels, as investors question whether or not a default will become necessary and what contagion effects it might have.  The biggest concern is that a default could lead to a Lehman like effect halting liquidity as banks and investors question each other’s exposure to the defaulted debt potentially leading to a significant funding issue for seemingly non-effected nations.  On this note, the German backed-bailout was not just a rescue of its profligate neighbors, but also its domestic banks, which are said to have significant exposure to the bonds in question.  In any case, trader sentiment toward the Euro is likely to remain weak as spreads drift higher for economically weak nations as the fine balance between effective fiscal austerity and growth is hopefully discovered. 

 Aggregate 10Y Government Bond Spreads Over Germany:

Source: Bloomberg

As an aside, over the past week Belgium yields have experienced the largest increment of the 20 European nations I track, which should continue to be monitored.  Belgium has one of the largest debt to GDP ratios in the region, a relatively weak fiscal deficit, and regional and political strife.  As the situation in Europe deteriorates, investors will likely continue focusing on Belgium, a trend that can already be seen through the past week’s spike in yields.  Prior to now investors had given the credit a pass partially due to a history of positive primary surpluses and its historical precedent of reining in wavering finances.  Belgium’s debt to GDP ratio is expected to climb to over 100% of GDP by the end of this year.  

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