Bond sell-offs result in higher interest rates, compounding the problem. Ten-year Irish government bonds are above 8%, and at a record spread above the relative safety of German bunds.
Irish banks are still issuing mortgages at 5%, despite facing longer-term funding costs of 8%, in an effort to buoy home prices. Without this support for the housing market, banks fear waves of defaults and foreclosures.
European banks could be pressured by higher funding costs, as government bonds typically form the floor upon which all rates are based. Additionally, bank capital could suffer from losses on holdings of foreign government debt.
For example, UK banks are the largest foreign holders of Irish government debt. Consumers could see borrowing costs rise and increases in fees.
Weak banks would be less able to extend credit, and the lack of additional sizeable monetary stimulus from the European Central Bank (ECB) means that money supply and lending could contract. Credit extension, the lifeblood for growth, could be impaired, reducing European growth.
Despite Irish bank problems, the crisis hasn't rocked stock markets, largely because the government raised capital earlier this year and is fully funded through the middle of 2011; and the ECB is intervening to assist in funding needs.
We are encouraged that measures of European intrabank stress remain contained despite the sell-off of troubled government bonds, suggesting that contagion risks, where problems of one country spread to others, appear to be limited for now.
The bottom-line? Slower growth in Europe is likely due to hampered lending, and bondholders could suffer losses with the threat of debt restructurings.
While growth in advanced nations is subdued, emerging markets heat up
Advanced economies need low rates to support growth that remains sluggish. However, low rates reduce the risk-free rate and fuel "carry trades," where traders borrow cheaply in currencies of advanced nations and invest in potentially higher rate and return investments in emerging nations.
Capital inflows into emerging markets could pump up growth and stoke inflation and/or currency appreciation. However, with the exception of India, core inflation remains subdued because of excess output capacity.
For now, the influx of capital has the potential to fuel future bubbles, but the emerging markets' bull run could continue. The liquidity provided by the Federal Reserve via QE2 is scheduled to continue through June 2011, although higher-than-expected US economic growth could reduce this program sooner. Higher growth in emerging markets in an era where growth is scarce could result in a premium paid for growth.
We are still bullish on the emerging market story longer term, but are becoming uneasy about the one-sided nature of this trade where even famed value and bond investors have positive views on this asset class.
While there is no near-term catalyst to end this momentum run, spiking inflation and aggressive tighteningāor a surge in the US dollar could result in a sell-off. New investments into this asset class should be made cautiously, using sell-offs for entry points.
