Debt Worries Roil Markets

Investors Fear Contagion of Greek Crisis, Washington Stalemate Over Deficit

By TOM LAURICELLA, MATTHEW PHILLIPS and E.S. BROWNING

The Wall Street Journal

Worries about government debt rocked capital markets on both sides of the Atlantic Monday, as fears that the Greek crisis will spread combined with concerns at the standoff over the U.S. debt ceiling.

The selloff started in Europe, hitting bonds and stocks in countries regarded as vulnerable to contagion from Greece, and spread to the U.S. where the Dow Jones Industrial Average ended at its lowest level since late June after a wild session.

Adding to the market woes were indications that, after months of shrugging off the debate over the U.S. debt ceiling, investors are getting edgy over Washington inaction ahead of an Aug. 2 deadline. The discomfort was reflected in the recent underperformance of the 30-year Treasury bond, traders and analysts said.

Yields on 30-year Treasurys—which move inversely to prices—haven't fallen in lock step with shorter term Treasury bonds in recent weeks, even as other assets seen as "safe havens" in times of trouble, such as gold, have continued to hit fresh highs.

"It is the political process in Europe, with the stuff that is going on in Italy, Spain and Greece, and it is the political process in the U.S. The closer we get to this August deadline, the more anxious investors become," said Andy Brooks, head of U.S. stock trading at asset-management firm T. Rowe Price in Baltimore.

Asked which was the bigger problem for the stock market, Mr. Brooks said, "Europe is more on people's minds because they seem a little more challenged."

Starting with the sharp selloff in Italian bonds just over a week ago, financial markets are showing classic signs of contagion: Investors, worried about troubles in one place, sell in another, creating a downward spiral that feeds on itself.

In this case, the primary worry has been about Greece but the involvement of Italy, a much bigger economy seen as the linchpin in the broader stability of the euro-zone, has upped the ante in the European debt crisis. With Italy under strain, along with Spain, European corporate bonds began to feel the pinch Monday, along with stocks across the Continent.

Yields on benchmark Spanish and Italian bonds reached the highest levels since the launch of the euro in 2002 Monday as investors fretted that the European authorities weren't doing enough to contain the Greek crisis. The release of "stress tests" of European banks last week didn't help: Findings that only eight out of 90 banks tested had failed were greeted with near-universal skepticism.

"The stress tests did not offer any new information and the market has gone back to what it was doing before—that is, sell the periphery," said Richard Kelly, head of European rates and FX research at TD Securities. The negative mood spread to European stock markets, with the Stoxx 600 index of European shares closing at its lowest level of 2011.

The market's jitters raise the stakes for a European summit on Thursday aimed at discussing the Greek crisis.

The U.S. stock market took its cue from its European counterparts, plunging as much as 183.50 points during the day before regaining almost half of that decline to close down 94.57 points at 12385.16—its biggest point and percentage drop in a week and the lowest close since June 29.

Even with all its recent volatility, the Dow is still up 7% since the year began.

That recent volatility has pushed Treasury prices higher this month as investors sought safe havens. But as the stalemate continues over plans to raise the debt ceiling by Aug. 2, investors are growing worried.

The lackluster performance of the 30-year Treasury has caused the gap between the yield on shorter-term Treasurys, such as the 10-year note, and the yield on the 30-year bond to reach its steepest level since November 2010.

And the rise in that gap—known as the yield curve—suggests to some that investors in long-term Treasurys may be getting turned off by indications that a big deal to cut national debt doesn't seem to be in the cards.

"This tells me that this is where the risk premium is being priced for the debt ceiling debate," said Jim Caron, global head of interest-rates strategy at Morgan Stanley. "One of the reasons is because any time there's any question mark around fiscal conditions, the 30-year bond—the longest maturity bond—will take the brunt of the pain."

Contagion has become a persistent worry for European and U.S. investors. Even though markets have notoriously short memories, few have forgotten the damage inflicted on their portfolios when the collapse of Lehman Brothers Holdings Inc. in September 2008 ricocheted throughout the global financial system.

"People have a template in their minds and that is the collapse of Lehman," says Gravelle Pierre, portfolio manager at hedge fund manager Iron Harbor Capital Management.

The lesson of Lehman Brothers for investors was that it is best to sell first, and come back to fight another day.

Italy is particularly vulnerable to contagion. Prolonged higher interest rates resulting from a bond market selloff could be dangerous for Italy because of its sizable need to borrow in the financial markets.

Higher rates could lead to a vicious cycle where a selloff in the bond market feeds on itself and becomes an Italy-focused problem.

At roughly €1.6 trillion ($2.3 trillion) Italy's bond market is the third largest in the world behind the U.S. and Japan. Over the past year Italian bonds have become widely owned by managers who have shunned the bonds of Greece, Portugal and Ireland. Many felt that Italy was walled off from the problems of the other peripheral countries.

Italy's main issue is its high level of debt in relation to gross domestic product, which stands at 120%. Given Italy's slow growth prospects, the current environment warrants the kind of higher yield levels brought about by the selloff, some investors said. Recent austerity measures are unlikely to help much, they say.

Still, Italy's progress on a $56 billion deficit-cutting plan is a step in the right direction, investors said. And although Italy's ratio of debt to GDP is hefty, it has been stable for years.

"I couldn't see from the data why Italy would overnight become a problem," said Asoka Woehrmann, chief investment officer at DWS Investments.

Instead, Mr. Woehrmann, said the selloff bore the hallmarks of contagion.

William Porter, head of European credit strategy at Credit Suisse, said last week's selloff was 30% a reflection of Italy's issues and 70% the issues in Europe. It was "pretty scary," Mr. Porter said.

The selloff "was a wake-up call," he says, and shows why investors should be wary of contagion.

—Damian Paletta and Mark Brown contributed

to this article.

Write to Tom Lauricella at tom.lauricella@wsj.com and E.S. Browning at jim.browning@wsj.com