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Will Europe's rescue plan work? Watch the bond market

October 26, 2011 |  7:59 pm

Flags
The verdict on Europe’s latest attempt to end its government debt crisis may be most apparent in the continent's bond market Thursday.

If investors sharply push up yields on the bonds of the Eurozone’s financially troubled states, it will signal a lack of confidence in the plan that emerged from European leaders’ summit.

But if yields fall, Europe may be able to finally declare victory in containing the two-year-old debt crisis.

Early Thursday in Brussels, European heads of state and major banks announced that they had agreed to a voluntary 50% writedown of Greek bonds as a way to slash the country’s debt burden. Banks most likely will exchange current bonds for a reduced principal amount of new debt.

The idea would be to give the devastated Greek economy more room to recover by slashing debt payments. But the writedown also would mean losses for the banks, which already face the prospect of raising fresh capital to bolster their balance sheets by mid-2012.

So another key element of the debt-crisis plan is the expansion of Europe’s $600-billion rescue fund for member states and banks. The focus has been on giving the fund -- known as the European Financial Stability Facility -- more firepower to show that authorities are serious about dousing the debt crisis once and for all.

French President Nicolas Sarkozy told reporters early Thursday that the EFSF would be leveraged four to five times to boost its ability to backstop struggling states. One expectation is that the fund would issue guarantees on bonds issued by deeply indebted countries, particularly Italy.

The goal: bring down interest rates on those bonds by making investors more confident about buying them.

The annualized market yield on two-year Italian government bonds has surged to 4.56% from 2.88% at the start of the year. By contrast, Germany pays just 0.52% on two-year debt. On 10-year Italian bonds the yield now is 5.93%, up from 4.82% at the start of the year and 3.73% one year ago.

“Italy has a lot of debt to roll over during the next three years,” said Nic Colas, chief market strategist at brokerage ConvergEx Group in New York. If market yields rise further, the country’s ability to finance its debt would become much more doubtful.

It’s already too late for Greece. But the fear all along has been that rising borrowing rates would bring down much bigger countries in the Eurozone, triggering a new global financial cataclysm.

So the bond market’s reaction Thursday will be key: Will investors have enough faith in the rescue plan to allow bond yields to fall in Italy, Portugal, Spain and other troubled countries?

RELATED:

Italy pledges reforms as part of debt-crisis plan

German Chancellor rallies support for rescue plan

-- Tom Petruno

twitter.com/tpetruno

Photo: The flags of the European Union and Greece flying in Athens. Credit: Louisa Gouliamaki / AFP/ Getty Images

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