Higher interest rates coming from EU crisis contagion as bonds fall

Sat thousands of miles away in North America or the Middle East, the debt crisis now engulfing several nations in the European Union might seem a long way away. But global finance is a small village as the world crisis of two years ago reminded us.

What we are starting to see in the EU is the inevitable market reaction to high debt levels. Namely the price of money, or interest rates, goes up. For there is a market competing for funding and in order to attract money to less attractive risk prospects a higher return has to be paid.

Bond prices falling

A return to almost pre-crisis interest rates on Dubai bonds might have heralded better times. But that is not the signal now emerging from Europe.

Spain’s 10-year bonds yesterday saw yields go above five per cent. Irish bonds jumped to 8.9 per cent, just short of a record high the day before rumors of its bailout. Portuguese bonds also went above seven per cent. And as for Greek 10-year bonds, they hit 12 per cent for the first time since May.

But it did not stop there. German 10-year bond yields rose to 2.7 per cent, as the market reflected on the cost Germany will have to pay for bailing out the EU.

The problem is that unlike the Dubai debt crisis a year ago there is no easy solution. There is no Abu Dhabi big enough to pay off the debts of Spain. The EU and IMF will be stretched enough to deal with Ireland.

Systemic debt crisis

What comes next is a systemic debt crisis. You do not want to own government bonds in this period. For yields will rocket, as in Spain, Portugal, Ireland and Greece, and bond prices will automatically fall as a consequence.

We can also reasonably guess that this is just the first step. All the indebted nations of the world will have to go through something similar as Professor Roubini is now warning (click here). Step forward Italy, France, Britain, Japan and the US. Indeed, one reason for the IMF and EU to help Ireland is to try to slow the spread of the crisis and unwind the process more slowly.

The Federal Reserve has placed its bet on inflationary growth to deal with the US debt problem. However, this involves pushing up debt even higher and the growth to date has been very weak. Yesterday’s jobs and consumer confidence data rallied stocks but actually the previous day’s housing sales disaster more than cancelled this out (click here).

For without a recovery in the US housing market the US debt crisis can only get worse. And the next thing coming are higher interest rates as the EU financial crisis spins out of control. Ireland may well default when its government loses the election early next year.