I'm ashamed to say world markets may again need to go on Europe Watch. The risk has risen to a level that local nerves over sovereign debtwill fray to the point that they have a material impact elsewhere.
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And I'm ashamed to say that because the situation appears to have been exacerbated by Europe's politicians managing, yet again, to shoot themselves in the foot, due to what I can only assume is either rank arrogance or ignorance towards markets.
At last week's European Union summit, the German Chancellor kept her fellow leaders up into the early hours of the morning demanding that, like cans of worms, hard-won treaties be opened up to permit the EU to strip voting rights from members who persistently fail to bring their debts down.
Angela Merkel failed. But she did get a promise that in December they'll have a detailed discussion on a new, permanent bailout system, which she insists will punish private sector bond holders. And so the damage was done—Angela Merkel-style.
The snail-like pace at which EU leaders stepped up to the plate this spring to stem the loss in Euro Zone confidence was at best negligent. But at least IMF involvement, the creation of a $600 billion bailout fund and direct ECB bond buying gave some credibility to the 'no default' mantra. Many still didn't believe it. But now even that rhetoric has changed.
ECB President John Claude Trichet warned EU leaders that their borrowing costs would rise. And sure enough, this very public washing of dirty laundry so stunned investors that bond spreads shot up this week. As the storm over European sovereign debt gets slowly worse, the eye of the present storm remains Ireland.
Dublin is desperately trying to convince investors it can bailout its banks and still stay solvent. It announced another $8.5 billion in spending cuts yesterday—that's 3.6 percent of GDP.
But still, spreads widened to a devastating 530 basis points above German bunds. (We used to use 500 as the 'point of no return' rule of thumb). Realizing the Irish government's promised 4-year plan to crack the deficit may now prove make-or-break, the government is reportedly delaying it beyond the next couple of weeks.
- Track Sovereign Credit-Default Swaps of PIIGS Nations
Meanwhile, on the foreign exchange markets, today's short-covering rally on the dollar not withstanding, the Euro continues to ride high. That's purely because FX traders tend to profit from being obessed with one thing at a time—and it's currently QE2 from the Fed and a weaker dollar.
But the by-product, a strong single currency, is the last thing peripheral Europe needs right now. Moreover, it is masking a situation in Europe that world investors may not be able to ignore much longer, even if Europe's politicians chose to, for the moment at least.