Learning to spell contagion

One of my mother's favourite refrains when I was in high school was "stay away from your friends who make trouble". Implicit in her exhortation was that one could be "friends" while avoiding their company. It was an exquisite bit of grown-up logic that my young brain, then, never really understood. Decades later, there is a ring of serendipity (and a belated hat tip to maternal wisdom) as the contagion from the Greek crises spreads to the "core" European countries.

It is, as if, the troublesome economy of Greece has affected the rest of Europe. On the face of it, this is a seemingly absurd idea. After all, countries ought to be able to chart their destinies in accordance with their economic strengths and industrial capacities. Yet, global capital imposes unique constraints on the rest of the Eurozone members.

As of writing this, the yield on two-year Spanish bonds has risen 15 basis points to 5.74 per cent. The ten-year yield has risen to 6.60 per cent after a five basis point rise overnight. Far removed from the Iberian Peninsula, but closer to North Atlantic Europe, the ten-year Belgian bonds rose 15 basis points overnight. In Italy, much like its carnivalesque political world, the yield curve has turned upside down — the two-year Italian bond has a higher yield at 6.76 per cent than the ten-year yield at 6.72 per cent.

High risk

In a bit of late breaking, but important news, the auction of ten-year German bonds was weaker than expected. Presumably, why hold euro denominated debt when the world offers debt instruments in dollars, yen and other "safer" currencies!

This kind of data poses an interesting question. Do individual countries in the Eurozone and their efforts to manage their macroeconomic budgets matter anymore? If not, why should any particular country in the Eurozone pull more than its weight vis-a-vis any requisite structural adjustments that might be needed to put the house of Euro in order? If yes however, why are the markets signalling that they treat all the sovereigns of the non-German part of the Eurozone with the same doubt? Conventional, and some academic, wisdom has told us individual countries' debt burdens have been responsible for the Eurocrises (thanks, in parts, to bank bailouts). The European Union as a whole has an average debt to GDP ratio of around 80 per cent. However, Greece has a ratio of 142 per cent, Italy has 119 per cent and so on. In a definitive work on economic crises by Professors Ken Rogoff and Carmen Reinhart called This Time is Different, they argue anytime a country's debt to GDP ratio breaches the 80-90 per cent threshold, historically, default and restructuring has followed.

But these numbers of European debt-to-GDP ratios are hardly new. So why are the bond markets exacting a premium now?

New research work indicates markets did treat Eurozone countries differently. Professor Paolo Manase at the University of Bologna and Guilio Triglia from the University of Warwick argue the era of "risk decoupling: is over. They show for a brief while (March to September), Ireland, Greece and Portugal were treated as macroeconomic anomalies and the rest of Europe were treated as "safer" bets. Some time in September, the bond market began to view the Eurozone, en masse, as high risk.

The researchers arrive at this conclusion by looking at the contribution of the domestic CDS spreads in Eurozone to a fictional statistic called Eurozone risk (measured as the variance of the sovereign CDS spreads). They evaluate by how much each country's sovereign CDS correlate with the Eurozone risk and see distinct regime shifts in market perception.

What went wrong after September?

The answer clearly is politics. Dithering over how to handle Greece, what kind of structural adjustments have to be made, which agency will contribute how much led to the bond market losing confidence any kind of solution was in sight. We now have a Euro-wide bearish sentiment. Equity indices have closed lower, recession is widely expected and political heads have begun to roll. Neither leadership nor vision is anywhere to be seen. Until then, as global exports to Europe diminish, the bond market will force the rest of us to learn to spell one word: C-O-N-T-A-G-I-O-N.

— The columnist works for a major European investment bank in New York City. All opinions are personal and don't reflect any institutional perspectives.