EUROPE´S DEBT CRISIS RUMBLES ON / THE WALL STREET JOURNAL ( HIGHLY RECOMMENDED RADING )

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FEBRUARY 22, 2011.

Europe's Debt Crisis Rumbles On

By RICHARD BARLEY

Europe is sitting on an active volcano. For the moment, the tension in Europe's bond market is being relieved by European Central Bank purchases and the hope that the March 24-25 euro-zone summit will comprehensively address the currency bloc's problems. But the risk of disappointment is high: Some of January's euphoria has been squeezed from the bond market, but it remains vulnerable.


Portuguese 10-year yields have risen to 7.5% and have only been restrained from spiking higher by ECB purchases. The country has raised around a third of its 2011 borrowing needs. But the market still assumes it will require support. J.P. Morgan has estimated the ECB has bought €16 billion to €17 billion of Portuguese bonds since May, almost the total issued over that period.


True, Spanish government bonds have escaped contagion: 10-year yields have fallen this year to 5.25%. There has been welcome news from Spain, which is working on the problem of its savings banks, and where economic growth rebounded in the fourth quarter. But execution risk remains both on the budget, particularly because much spending is at the regional level, and in the banking sector. Spanish bond yields also remain vulnerable to any disappointment over plans to make the euro-zone safety net bigger and better.

The euro-zone political weather is also likely to get heavier. Ireland votes on Friday and a new government is almost certain to renegotiate its bailout package. German Chancellor Angela Merkel has lost Axel Weber as prospective ECB president and an election in Hamburg; she faces two more regional polls just two days after the March summit, which may make her less willing to compromise on revamping Europe's bailout system. The Bundesbank has just warned of the risks to creditor countries of increasing the size of the bailout facilities.


For now the market is polarized between hope and fear. Both sides are at risk: A solution will drive Spanish and Italian government-bond yields lower; a disappointment could lead Spanish spreads over Germany to balloon to three percentage points, RBS reckons. Investors should be cautious as long as the euro-zone debt crisis remains alive.
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