Rising bond yields reflect European worries

Yields on bonds issued by the governments of Spain, Italy, and Greece have been on the move upward, a worrisome sign that global investors remain skeptical about a resolution of the European sovereign debt crisis.

The increases for both Spain and Italy, which accelerated this week, have pushed their yields above the psychologically important 5-per-cent level for longer term borrowings, and breaks a period of relative calm following a decision by the European Central Bank to offer cheap three-year loans to banks and the recent debt swap for Greece bonds.

The rise in bond yields signals that "Europe worries return," commented Michael Hewson, senior market analyst at CMC Markets in London, in a note to clients.

Because yields and bond prices move inversely, the trends in the market indicate that a large number of investors have been dumping their bonds, driving down prices in the absence of enough buyers, although some of the selling pressure abated in late Friday trading.

Mr. Hewson said the bond market action fed into anxiety this week toward European stocks, "bringing the recent rise in equity markets to a shuddering halt. This has raised concerns that the recent good run in equity markets could be over and we could be heading back down again."

European stocks, which have been on a tear for months, posted their worst weekly drop of the year.

Until this setback on the bond market, hopes were riding high that Europe's debt woes might be on their way to being solved, or at least placed on the back burner for a while.

Earlier in March, Greece successfully engineered a swap of privately held government debt for new bonds with longer maturities and lower interest payments. Meanwhile, the ECB forestalled a Lehman Bros.-style collapse in Europe's financial system by injecting a total of €1-trillion ($1.3-trillion) in three-year loans into hundreds of banks in separate actions in late February and December.

The ECB liquidity removed the possibility of a immediate banking crisis, and as another plus, provided banks with extra funds that they could use to buy sovereign debt, propping up their prices.

But with the latest move upward in yields, it appears that the crisis is continuing to simmer, although few analysts are predicting an immediate move back into the extreme conditions prevailing late last year, when there were worries that much of the continent's banking system was edging towards collapse and Italian bonds fell so low they yielded more than 7 per cent.

One reason for renewed worries are signs that the economic downturn in Europe – where Belgium, Ireland, Italy, Portugal and Greece are in recession – might be becoming more severe.

"The issue with Italy and Spain is that, of course they have serious challenges ahead of them and the economic situation, the broad macro-economic picture, is not helping," said Martin Schwerdtfeger, senior economist at TD Bank Group.

Highlighting the economic jitters, the Euro-zone composite PMI, an index that shows the sentiments of purchasing managers, fell in March for the second month in a row, according to figures released this week. The PMI levels reported suggest recessionary conditions are prevailing in Europe.

Although the ECB liquidity and the debt swaps for Greece removed the threat of an immediate financial calamity, the various problems at the root of the crisis haven't changed.

"The fiscal situation for these countries is still the same. They are confronting extremely weak economic growth or in many cases, outright recession, high unemployment, rising unemployment," said Mr. Schwerdtfeger.

Europe's markets will likely remain volatile until governments bring their finances under better control and economic growth resumes, a process that could take years.

Until then, investors should get used to big swings in yields as a normal part of trading. "I think it's going to be the natural reaction of the markets to this crisis. This is something that is going to be with us for a long period of time," Mr. Schwerdtfeger said.