Like a Halloween party hangover, the European sovereign bond market is feeling little chills and sweats following the weekend's EU pact on fiscal governance. You will recall that Germany struck a deal with France to modify the EU Treaty and create a permanent mechanism for dealing with troubled EU sovereign debtors.
What we have therefore is a vague plan that will ride roughshod over the EU's principles: no bailouts for sovereigns, no defaults and no permanent slush fund. But the main idea that the market is coming to grips with is that in some parallel euro zone universe there will be managed defaults.
Following the weekend deal, an executive board member at the European Central Bank, Lorenzo Bini Smaghi, criticized the failure of the euro zone leaders to come up with a deal which would bind governments to fiscal discipline enforced by the European Commission. More interesting, he also said that any rescue mechanism for EU sovereign borrowers should envisage preferred creditor status to institutions such as the IMF or ECB.
No surprise then to see Irish, Greek and Portuguese bond yields climbing this week. Anyone who punted on these sovereigns ought to be feeling a bit queasy at the idea that the €800-billion European slush fund could be replaced by something permanent, a mechanism that must imply a haircut for ordinary bondholders in favour of preferred status for some rescuing institution.
Elsewhere, bond realism is unfashionable. Do we really think that a spread of just 50 basis points between the 10-year sterling gilt and the equivalent German bund reflects the relative fortunes of Germany's solid industrial exporting machine and Britain's threadbare, debt-burdened casino economy. What about a spread of just 40 basis points for French debt versus the bund? Meanwhile, the rush to buy emerging market debt continues. Bloomberg on Tuesday reports the fashion for emerging market junk bonds. Apparently, the spread between junk and investment grade in developing countries has narrowed to its slimmest margin since the market's peak just before the 2008 financial crash.
This is a swelling bubble, inflated by investment managers frantically searching for higher yields that will deliver better returns. If you pursue this, you must believe the global economy is out of the woods. I see only a lot of dark trees.