LONDON (Reuters) - Government borrowing costs in Europe’s indebted southern countries shot up on Monday as investors began to worry that a vote in Greece could see it become the first country to leave the euro currency bloc.
Euro zone debt markets saw a glimpse of the contagion that spooked investors at the height of the debt crisis in 2012, but borrowing costs in Italy, Spain and Portugal were still less than half the levels seen back then.
The rise in bond yields in these three countries, seen as the most vulnerable to spillovers from Greece, was sharp - 20 to 30 basis points - but could not match moves seen in May when investors raised their inflation expectations.
As talks with international creditors over a reform-for-cash deal broke off at the weekend, Athens closed its banks and introduced capital controls, pledging to hold a vote to see if Greek people will agree to its lenders’ demands on Sunday.
Investors see it as a de facto vote on euro membership.
If Greece were to exit the euro zone it could raise the risk for investors that other heavily-indebted member states might follow suit. But while the probability of that scenario has risen, it is still not the base case in the market.
Polls have shown the majority of Greek people want to stay in. Odds from bookmaker Paddy Power show a two-in-three chance that Greece votes to accept its creditors’ terms.
Moreover, the European Central Bank is less than four months into its trillion-euro bond-buying stimulus program which runs until September 2016. The quantitative easing scheme could act as a cushion and, analysts say, could even be accelerated if contagion hurt growth and inflation prospects.
“The financial market is very much concerned about the implication of an unlikely exit of Greece from the European Monetary Union could have,” said Markus Allenspach, head of fixed income research at Julius Baer.
“That said ... the European Central Bank has much more powerful instruments at hand to limit the damage on the bond markets. We thus believe that there is no replay of the European debt crisis in the making.”
Spanish ES10YT=TWEB and Italian IT10YT=TWEB 10-year bond yields rose 20 bps to 2.31 percent and 2.36 percent, respectively, while Portugal’s PT10YT=TWEB rose 30 bps to 3.05 percent. They were all above 7 percent in mid-2012.
Yields on German 10-year Bunds DE10YT=TWEB, seen as a safe haven, fell 12 bps to 0.80 percent. The gap between Spanish and benchmark German yields hit its widest level seen in a year.
Bankers said trading was light in a market where it is increasingly difficult to buy and sell bonds and the ECB is hoovering up large amounts of debt via its QE program. This lack of liquidity is exacerbating moves.
The sharp opening jump in yields did not continue, but the pullback in yields from the day’s highs was fairly modest.
During the protracted talks between Greece and its creditors the market has shown great confidence a deal will be reached, but now some investors see substantial risk of “Grexit”.
Greece is set to miss a 1.6 billion euro ($1.76 billion) loan repayment to the International Monetary Fund on Tuesday. A default may prompt the ECB to increase the haircuts on the collateral it accepts to fund Greek banks, or pull the funding, a move which could put savings in jeopardy and stoke public anger in Greece against the euro system.
Greek bond yields rose by up to 16 percentage points, according to financial platform Tradeweb, although strategists cautioned that capital controls would likely restrict trading from domestic banks which hold most of the country’s debt.
Athens’ main stock market was closed on Monday and is due to stay shut all week. <0#GRTSY=TWEB>
“It’s tossing a coin ... but if I had to position myself I would do it on the side of a Grexit,” said Marius Daheim, senior fixed income strategist at SEB.
“This government was elected by a majority of the Greek population on an anti-austerity bill so for that reason I would assume that a lot of the same people who voted for Syriza earlier this year would also be voting against this reform proposal.”
Editing by Ralph Boulton