Ireland sneezes but little sign of globalised cold

10 Nov 2010 Jeremy Gaunt, European Investment Correspondent

LONDON (Reuters) - About six months ago, the euro zone debt crisis was hot enough to trigger headlines like "Wall Street falls on worries about Greece". It was all about contagion, fears that default in economic minnow Greece could spread not just to Portugal and Spain but beyond, crushing the euro zone in its wake. Tensions are increasing again about debt in the euro zone periphery - particularly Ireland - with some yield spreads and debt-insurance costs at record levels.

But to date there has been little sign of global contagion, primarily because investors have been looking elsewhere - mainly the Federal Reserve - and because of crisis management programmes that can now be employed by policymakers. The spread between Irish 10-year bonds and German Bunds hit a record 571 basis points on Tuesday, up from around 300 at the height of the crisis and a good 200 above where it was in mid-October.

Greece, too, is back up to uncomfortable levels, if not as wide as at the height of the crisis, and Portugal's spread has widened to a record as well. The impact further afield, however, has only been felt mildly so far, mainly on the euro, and even then only in the past day or so at a time when the dollar has been rising broadly anyway. "Markets fear of contagion has fallen," said Klaus Wiener, head of research at Generali Investments in Cologne. "In May, the escalation of the debt crisis in Greece threatened to end in a systemic crisis. This fear is not as pronounced any longer." The 30-day correlation between the movement in peripheral bond spreads and the euro was around -0.6 in May, meaning that widening in spreads was usually matched by euro weakness.

That correlation is now close to zero for Ireland and only slightly negative for Greece, suggesting that at least over the past month the debt problems have been isolated, having little if any impact on the currency. It is more or less the same story with stocks. In the past three weeks as the Irish spread has widened 200 basis points, the pan-European FTSEurofirst 300 stock index has gained more than three percent. It was up three-quarters of a percent on Tuesday as the spreads widened to another record.

Globally, stocks have paid even less attention, with MSCI's all-country world index rising around 4 percent over the period. Data from iTraxx, meanwhile, shows that investors are pricing in the chances of default in European companies as less than that for Western European sovereigns -- not good news for sovereigns but hardly a thumbs down for corporates, which suggests fear does not stretch to a systemic crisis which would surely engulf companies as well.

DIFFERENT CONDITIONS
There are two main reasons why the market impact from the renewed debt worries has been muted so far. One is simply that investors have had their minds on other things, notably the $600 billion quantitative easing programme launched by the Fed last week to stimulate the U.S. economy. The global economic picture has also improved, with even lagging U.S. jobs creation ticking up. "The big theme was quantitative easing, the economic cycle. It is undeniable that the data has been positive, almost globally," said Joost Van Leenders, investment specialist at BNP Paribas Investment Partners in Amsterdam.

The second big reason is that investors believe lessons were learnt in the earlier Greek crisis and policymakers stand ready to stop disorderly default contagion. Since June, a European stabilisation mechanism has been in place, funded by the European Union and International Monetary Fund, to provide as much as 750 billion euros at relatively low interest rates to euro zone countries needing them. No money has been taken, but it is seen by many as a safety net. There are also plans afoot to create a permanent mechanism. Although political differences will make agreement hard, the mere fact that it is under discussion underlines the willingness of authorities to act. None of this is to say that the current stresses in Ireland and elsewhere are negligible. It is inconceivable, for example, that a default or restructuring in Greece or Ireland would not have wider impact.

But the lack of sharp reaction outside the countries concerned so far does suggest investors are not expecting a blow up across markets similar to the one earlier this year.