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Bond yields surge in Europe as 'contagion' fears spread

July 6, 2011 | 11:29 am

Europe's debt crisis is going from bad to worse -- again.

Investors dumped government bonds of Portugal, Ireland, Italy and Spain on Wednesday, driving market yields up sharply, after Moody’s Investors Service late Tuesday slashed Portugal’s bond rating to junk status.

The bond sell-off slammed the euro and also helped drive most European stock markets lower for a third day.

Portugal2yr The annualized yield on two-year Portuguese bonds (charted at left) soared to a record 16.74% from 12.94% on Tuesday.

Moody’s said its downgrade was triggered by “growing risk” that Portugal will need a second bailout by the rest of Europe, and that private bondholders could be forced to participate in a bailout as a precondition for more aid.

European governments are pressing private investors in Greek bonds to agree to restructure that country’s debt as part of the euro zone’s planned second bailout of Athens, which is being crushed by a debt burden of nearly $500 billion.

Moody’s clearly is worried that a Greek deal with private bondholders could set the stage for Portuguese bondholders also to be forced into concessions, such as taking a cut in their interest earnings.

By fleeing Portuguese debt and driving borrowing costs to extreme heights, investors are making it more likely that Portugal will be unable to raise money in the bond market and thus will be forced to seek more aid from the rest of Europe.

What’s more, the latest surge in yields on Irish, Italian and Spanish bonds raises the risk that the debt crisis could turn into a wildfire in European markets, threatening another financial-system meltdown.

Moody’s downgrade of Portugal “highlights reoccurring doubts about the ability of euro zone policy makers to ring-fence contagion and in turn stymie the eroding market confidence,” currency analysts at Brown Bros. Harriman said in a note Wednesday.

Moody's decision evoked an angry response from the European Union, which accused the company of anti-Europe bias.

Ireland2 But investors voted with their feet: The yield on two-year Irish bonds (charted at right) jumped to 15.31% from 12.88% on Tuesday.

Italy and Spain still pay much less to borrow than Portugal and Ireland, but yields on Italian and Spanish bonds also jumped Wednesday. Italian two-year bond yields rose to 3.27% from 3.09%; Spanish two-year yields rose to 3.62% from 3.43%.

U.S. two-year Treasury notes, by contrast,  pay just 0.43%.

The euro tumbled 0.8% to $1.431 from $1.443 on Tuesday, though it’s still well above its recent low of $1.405 on May 23.

In stock trading, Portugal’s main market index plunged 2.6%, the Irish market fell 1.4%, Italian shares slumped 2.4% and the Spanish market lost 1.2%.

-- Tom Petruno

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