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European Banks Trade on Sovereign Debt Fears

Spain is the most important domino.

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Just as the U.S. Federal Reserve was winding down its quantitative easing program at the end of March, we were harboring concerns about how much higher U.S. mortgage rates might reset with such a large buyer stepping back from the market. During the month of April, long idling but persistent rumblings regarding sovereign credit concerns around peripheral EU countries quickly grew louder, as a different link turned out to be the weakest in the global credit market chain. In the ensuing months, the cost of capital rapidly reset higher for European countries perceived to face the weakest combined debt/deficit/economic pictures, most prominently Greece, Portugal, and Spain. Based on market action, it appears that there are also some lingering concerns about Ireland, Italy, and the U.K.

It is somewhat of a chicken or egg argument about whether some of these countries potentially faced solvency issues that caused the debt markets to react so negatively or vice versa. What we find undeniable is that a rapid reset higher in the cost of credit for already troubled countries increased the odds of a bad outcome for any particular country. This situation closely mirrors what happened in the U.S. with its most financially troubled households. When the cost of (and access to) mortgage and credit card debt quickly reset in adverse fashion, the already high odds of default jumped overnight.

Matthew Warren does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.