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Italy and Spain rocked by fears of spreading debt 'contagion'

July 8, 2011 | 11:10 am

The dismal U.S. jobs report for June is getting most of the attention on Wall Street Friday, but the greater risk to the global economy may be the spreading debt crisis in Europe.

The “contagion” that has forced Greece, Ireland and Portugal to seek bailouts from the rest of Europe now is threatening Italy, as investors demand ever-higher interest rates on Italian government bonds.

The yield on two-year Italian bonds (charted below) surged to 3.51% on Friday, the fifth straight increase and up from 3.32% on Thursday. On Monday the yield was 3.04%.

Italy Likewise, Spanish two-year government bond yields jumped to 3.77% on Friday from 3.66% on Thursday and 3.35% on Monday.

The assumption that Greece’s private bondholders will eventually be forced to give some kind of concessions to keep Greece afloat already had fueled fears that owners of Portuguese and Irish bonds might have to do the same for those countries. Portugal's debt was downgraded to junk status on Tuesday.

This week concerns about the financial health of Spain and Italy hit those countries' markets with increasing force. The Italian stock market dived 3.5% on Friday, bringing the decline for the full week to 7.2%. On Wall Street, that would be the equivalent of the Dow index plummeting 900 points.

Spain’s main stock index tumbled 2.5% on Friday and dropped 5.3% for the week.

Worries about the health of Italian banks forced Bank of Italy chief Mario Draghi to publicly defend the country’s financial institutions Friday. He said he was confident they would pass a new “stress test” meant to determine banks’ ability to cope with economic turmoil.

Jens Nordvig, a currency analyst at Nomura Securities, summed up the situation in a note on Friday:

Providing a backstop for Greece, Ireland and Portugal was well within the capacity of core eurozone member countries (from an economic perspective, at least). But Spain and Italy are in a different league, together accounting for 28% of eurozone GDP, and 32% of eurozone government debt stock. It is fair to say that a funded bailout for Spain and Italy is not feasible.

From this perspective, runaway contagion in Spain and Italy would pose a real problem, with no obvious effective policy response in sight.

The euro was down 0.7% to $1.426 on Friday from $1.436 on Thursday. The currency was as high as $1.454 on Monday.

Global investors rushed back into U.S. Treasury bonds for safety, a move also encouraged by the bleak U.S. employment report. The yield on two-year T-notes slid to 0.39% from 0.47% on Thursday. The 10-year T-note dropped to 3.02% from 3.14%.

Gold also attracted nervous investors. Near-term futures in New York rose $11 to $1,541.20 an ounce, a two-week high.

-- Tom Petruno

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