European bond market faces another volatile year

28 December 2010 - 05H10

Photo illustration of euro notes. The European bond market is heading for another turbulent year in 2011, with investors groping for direction in the face of an uncertain US recovery and a stubborn debt crisis in the eurozone.

(L-R) IMF director Dominique Strauss-Kahn, European Central Bank president Jean-Claude Trichet talk on December 6, 2010 at the EU headquarters in Brussels. Analysts warn that even with the help of the European Central Bank, which since May has been trying to stabilise the market by buying from banks bonds issued by periphery countries, the eurozone's financial difficulties are likely to persist.

AFP - The European bond market is heading for another turbulent year in 2011, with investors groping for direction in the face of an uncertain US recovery and a stubborn debt crisis in the eurozone.

In 2010 bonds for the first time lost some of their attraction as a safe option, with investors shunning part of the market, according to bond strategist Patrick Jacq of BNP Paribas bank.

German and French bonds were the exception, with their yields falling to their lowest levels as investors who feared for the fate of the US economy saw such assets as a refuge.

But elsewhere sovereign bonds issued by eurozone members had a rough ride in 2010 in response to a debt and deficit debacle in Greece and huge financial pressures on the Irish banking sector.

Both Greece and Ireland, facing sharp hikes in their borrowing costs, eventually had to appeal for a bailout from the European Union and the International Monetary Fund.

The perception that European authorities had been slow to act on the Greek crisis rattled the market further, notably as banks held massive amounts of debt bonds issued by Greece, Ireland, Spain and Portugal, financially weak countries on what became known as the eurozone's "periphery."

Eurozone officials moved faster in response to the Irish banking crisis, determined to shield Portugal and Spain from having to be rescued with outside money.

Analysts now warn that even with the help of the European Central Bank, which since May has been trying to stabilise the market by buying from banks bonds issued by periphery countries, the eurozone's financial difficulties are likely to persist.

"The problem is going to flare up again if demand is insufficient when the peripheral states try to raise money in the market," said Vincent Chaigneau of Societe Generale CIB.

In the new year financial players will be looking closely at Spain's long-term borrowing operations as well as the first emission from the European Financial Stability Facility destined for eurozone states in financial straits.

For economist Patrick Artus of French bank Natixis, the principal risk in the new year is that Spain could find itself unable to finance its debt on the market.

Spain's economy ranks fourth in the eurozone and a rescue would be far bigger than anything seen to date in Europe. The size of its economy is twice that of Greece, Ireland and Portugal combined.

Artus said the focus should now be on ensuring a country's solvency rather than simply its liquidity needs.

Several solutions have been put forward, notably the creation of a permanent, well-endowed rescue fund -- already approved in principle at an EU summit -- and the launch of joint eurozone bonds, which would increase the chance of financially weak countries finding buyers for their debt.

There is likely to be debate as well on whether governments should pursue growth or austerity as a means of securing stability and whether the ECB should step up its bond-buying programme.