The selloff in bonds was halted this week as a worsening European market triggered a global flight to safety trade. The week ended with rates mostly unchanged, while the dollar was up ~2.5%. CDS spreads were wider by 4 basis points in the aggregate according to Markit’s 5-year CDS Index.

Bond trading was light in the holiday shortened week dominated by the ongoing European crisis. The market has rejected the move lower in rates that preceded QE2, but domestic investors who are beginning to require more compensation for risk continue to battle problems abroad that are keeping rates in the U.S. very low. In the short-term, as this round of problems in Europe back off the front page, a continuation of the trend higher in rates is likely to continue.

Messy Europe

Irish spreads widened again amid new fears despite a formal request for aid from Ireland. The request happened a week later than the market expected, but in line with expectations in terms of size. The problem however is far from resolved with two very large issues still blocking any real improvement.

First off, the European Sovereign problem is still dominated by fears of contagion. First it was Greece, then Ireland, and now the focus is moving toward Spain and Portugal. The only answer to the rolling panic so far has been emergency funding for countries who can’t afford to issue new debt to fund ongoing deficit spending. There are of course austerity measures that come with the bailout money, but so far cuts have been of marginal and growth expectations to carry the rest of the budget balancing are a bit unrealistic in my opinion. Contagions can quickly snowball out of control, which brings us to the second issue.

The bailout that was designed to end all the debt fears in Europe might not be big enough. The European Financial Stability Facility (EFSF) was funded with €750 billion, and has been used only on Greece to the tune of €30 billion. Figures for the Irish bailout are in the €90 billion range, and early estimates for a bailout of Spain are running at 7-9 times the size of Ireland’s. At those sizes, the entire fund is depleted before Portugal and Italy are dealt with. The bickering over austerity measures is already widening the rifts within the EU, so an increase in the pledges by Germany and France are probably out of the question at this point. In reality the problem might already be too large for Europe to fight with bailouts.

Rumors of mandatory haircuts on privately owned Irish bank debt over the weekend are making their rounds on a lightly staffed day on the street. Such an announcement may prove to be a short-term positive for Ireland’s Sovereign issue. Ireland’s ability to continue to stand behind their bloated banking industry has been disputed during this entire crisis, and by forcing the private sector to share the load of restructuring Ireland may gain favor among other EU members. We will have to see come Monday.

Standard and Poor’s announced today they have cut credit ratings of the largest Irish banks, including lowering Anglo Irish Bank from BBB to B (junk). Doubts over the Irish government’s willingness to support private bondholders were sighted as the main driver of the downgrade.

The countries in the most trouble are the ones least willing to do what is necessary to solve their problems. By leaning on the relative strength of Germany and France, Greece, Ireland and others were able to borrow much cheaper than they would as a standalone credit and way beyond levels that would be considered sustainable. More of the same risks creating a much larger problem down the road, and maybe even a breakdown of the EU.

I am surprised that they have continued to fight the problem this way for this long. I do not stand alone in my view that the bailouts will do little to solve the structural problems in Europe as evidenced by spreads that still sit at record highs. It will ultimately take a change in strategy to calm the stresses in the market, not because it won’t be painful, but because it might give the market a glimpse of how this whole mess might end. An announcement on haircuts this weekend might be the first step toward that.

Have a great weekend.