European bond traders are going for the jugular

If you look at the crisis in Europe, the key questions to ask are clear: Will this crisis continue to spread? And will the United States get singed by the fallout?

In both cases, the answer is a very clear “Yes.”

Whereas traders once were content to play around the edges by trashing Greece, Ireland and Portugal, now they’re going for Europe’s jugular vein. What I mean is that traders are now dumping the debt associated with so-called “core” European Union nations.

French and Austrian bonds, for example, sank to near record lows Tuesday, as yield premiums over German debt rose to 192 basis points and 184 basis points respectively, according to Bloomberg. Thursday saw the issue worsen, with the French-to-German spread at more than 200 basis points.

Yields and prices run in opposite directions. If yields are rising, that means prices are falling and vice versa.

At the same time, Italian yields again sliced through 7% — the level at which debt is regarded as unsustainable. That’s the second time in a week that’s happened.

Meanwhile, the Spanish premium over German debt hit 489 points Thursday, which is above the 450 point spread at which both Ireland and Portuguese banks were forced into bailout status.

As measured by a combination of credit default swaps, correlation and systemic risk, things are now worse than they were in 2008 at the depths of the financial crisis.

The way I see it, the EU debt market has become a two-way street, much the way our financial markets have become addicted to U.S. Federal Reserve funds. If the European Central Bank (ECB) is buying debt as part of a bailout, the markets rally. If the ECB is not, the markets fall.

There are no real EU debt buyers.

There are four reasons why this matters to us:

• When it was created in 1999, nobody ever envisioned that the euro would fail. That means! there h as never been a plan to step back from the brink if required. That’s one heck of an oversight in my opinion, so it’s no wonder that the majority of EU ministers are clueless right now.
• If the euro fails, every bank that holds euro-denominated bonds is going to lose money. European banks that can’t fend for themselves likely will default on monies owed to the U.S. institutions that have lent to them.
• Europe is the world’s largest trading bloc and purchases huge amounts of American goods. A European failure will cause purchases to drop, and the corresponding drag on sales, earnings and jobs here will be felt very quickly. At that point, both Europe and the United States will fall into another recession in 2012. This will effectively nullify the weak dollar policies to which the Fed has adhered on the assumption that American goods need a weak dollar to stimulate growth.
• European investors are the single largest source of foreign investment in the United States. A recession and capital drain in Europe will cause European companies that would otherwise invest here to keep their money at home.

What to Do When Europe’s Crisis Hits U.S. Shores

The only way out is for individual nations in the EU to print money now — which obviously raises the stakes significantly.

If the euro zone breaks up or is substantially restructured, German taxpayers, for example, may be required to make good on French debt loaned to Greek homeowners. Or Spanish businesses may have to kick in extra taxes to pay for Italian municipal failures underwritten by French banks. The permutations are endless and very complicated.

There’s something else, too.

Like citizens around the world, traders are tired of being lied to by politicians who lie to each other. And, most of all, they’re tired of not being able to adequately assess risk to the point where they can do their jobs.

So they’re takin! g matter s into their own hands.

This is what I mentioned was Wall Street’s worst nightmare a while back — that traders finally get fed up enough that they overwhelm central bankers and force interest rates higher, much in the way the so-called bond vigilantes did in the early 1990s.

By hook or by crook, it doesn’t matter why. That they have now centered their attention on core European countries does.

So now what?

I believe that the world’s governments and central bankers think they’re smarter than the rest of us and that they can manage the world’s economy better through central planning than capitalism can through private enterprise.

I also believe they’re dead wrong. They’ve been wrong since this crisis began and they’re still wrong.

Here’s how investors need to respond:

• Hold hard assets as a means of hedging the value of your investments and protecting your purchasing power.
• Include energy in your portfolio because it’s driven by demand, compared to debt, which is driven by clueless politicians throwing good money after bad.
• Bet on growth in the form of “glocal” stocks — global companies with a big presence in developing markets.
• Protect yourself with inverse funds that appreciate when the broader markets head south.
• Understand that it’s not “buy and hold” that matters any longer. Instead, it’s more like “buy and hold your nose.”

Yes, the risks are great, but the risks of getting left behind are greater — even if the payoffs are not immediate.

This article originally appeared on Money Morning.