Credit Markets Jittery Again

european debt crisisIreland and Greece’s sovereign debt problems have sent credit markets into turmoil again. Hardly surprising, considering that both countries are dealing with mountains of prime fiscal problems and have been reduced to Europe’s pariahs in more ways than just monetary. This is bound to have an adverse impact on the euro despite Germany’s export-driven soaring growth pushing it to new highs.

The markets are clearly afraid of the impact of Ireland potentially going up in flames. Fearing default risk, Irish bond yields have shot into the stratosphere relative to German government issues. Additionally, an index comprised of credit-default swaps, and that is used typically to gauge costs of protecting investors stuck with Greek, Irish, Portuguese and Spanish treasuries from non-payment, has actually more than doubled compared to six months ago. Incidentally, compared to six months ago, the euro has risen by about 15%, while currency observers expect it to gain an additional 15% in the next six months, for an estimated 30% gain in the 12-month period from mid-May 2010 to mid-May 2011.

What does the euro strength says about the Eurozone? It says that, collectively, the Eurozone is capable of weathering another sovereign debt crisis. Six months ago, the Eurozone’s central bankers and finance ministers agreed to help any member that finds itself in fiscal difficulties. To facilitate the rescue, Eurozone leaders have set up the European Financial Stability Facility and pumped about $1.0 trillion into it, which can be tapped into through loans and guarantees if and when the sovereign debt problems get hairy again.

To some, this is a sufficient reason to be cautiously optimistic. With $1.0 trillion on tap, currency traders might feel that, if there is a fire in one room, the whole house may not have to burn down to its foundations. The only problem with optimism is that the real test of both the euro’s strength and Eurozone’s unity will be if and when one of the bigger players ever becomes an increased default risk, such as perhaps Spain. Ireland, Greece and Portugal’s sovereign debt problems are big, but not dangerously big, because those countries’ GDPs are less consequential. In contrast, if for example Spain’s default risk increases or if Germany’s economic output suddenly evaporates, it would be a whole other ball game. To put things in perspective, in 2009, Ireland’s GDP accounted only for about 1.8% of the Eurozone’s total output, while Germany’s GDP accounted for 27%.

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Oddly, Germans are not particularly fazed by the euro’s performance in the past six months, in spite of it being a considerable drag on the country’s exports. The way this industrious nation of savers perceives it, Germany has returned to its old days of economic glory when its deutsche mark ruled Europe. Germans also believe that, if they are doing well, so would others in the Eurozone, now that the region is so deeply interconnected.

That said, the outlook for the euro and Eurozone’s credit markets is not that clear cut. Contrarians believe the euro has peaked and that it may soon be coming off its recent highs. It is true that large EU players have been plugging along and it is true that Germany is not showing any signs of slowing down…yet. However, the sovereign debt issues among the small players, despite their size, have been persistent and the main cause of the tizzy in the credit and currency markets. It is possible that Europe will survive its sovereign debt crisis, but if another Greece-like bailout is needed, things will not be pretty, for sure.