The Next Contagion

Back in 1997, we witnessed a currency contagion – hatched in Thailand, spreading quickly to the rest of Southeast Asia, smacking Russia in the gut and sinking a major player in the US derivatives market.

10 years later, came the debt contagion – incubated in a sub-sector of America’s mortgage market, which soon infecting nearly all credit instruments, striking Wall Street like a sledgehammer and mortally wounding the global financial system.

Now, the next contagion is beginning at a much higher level, in the most important financial instruments on Earth – long term bonds issued by sovereign governments. It could sabotage the plans of the US Treasury, the Federal Reserve and many of their counterparts overseas.

Just 117 days ago, on October 8, Greece’s benchmark 10-yaer bond was selling for 112.295 and today is has collapsed to 92.13 respectively. And the drama of its yield surge is even more striking – from only 4.41% to 7.14% - a jump of more than 60% in less than four months.

Already, this contagion is spreading to other countries. Portugal’s 10 year government bond reached a peak on December 1, 2009 just 62 days ago. And now it has also started to plunge virtually non-stop with its biggest declines registered late last week.

British government bonds – gilts – are equally vulnerable. Sovereign bonds in Japan, Spain and other major deficit nations are also starting to get hit.

Also, one should not deny the vulnerability of US government bonds, which typically viewed as the ‘least ugly’. This helps explain why US government bonds have not been among the first targets of the contagion. But that does not protect them from becoming one of the next targets as well.

The US government suffers from the same or worse underlying disease as Greece, Portugal or any other victim of the contagion – massive and out-of-control federal deficits. America’s burden was %1.4 trillion last year and another $1.4 trillion this year. It has grossly failed underestimating the size of the deficit and its potential impact on investor confidence and the speed by which its bond prices can fall.

The consequence of this complacency is catastrophe.