Two months ago this blog transmitted the alarm over Irish Worries for the Global Economy which were seen as heralding The Return of the Stress:

There are increasing signs that the semblance of normality we experienced over the summer could have been just a casual summer affair, after all.

We posted those words two months ago. The chart below, which was posted yesterday on the Calculated Risk blog, shows that yields are spiking for all the debt-distressed European sovereigns and that, among other things, Irish long-term bond yields are now higher than those faced by Greece in the last days before it was bailed out 6 months ago:

Long term borrowing costs for the weakest Eurozone nations had started falling in early October after rising in September, but have since resumed the underlying trend and are spiking sharply once again.

Although the “smart money” started taking positions a few days before, the action started in earnest on Monday, November 1st, when German Chancellor Angela Merkel drew a line in the sand on Eurozone bailouts and insisted that bondholders should take some of the pain. As Ambrose-Evans Pritchard of the Telegraph put it in his post Ireland is Running Out of Time:

The trigger for Ireland’s bond hell this week was of course the Franco-German deal preparing the way for orderly defaults and bondholder haircuts for eurozone states that get into trouble. This shift in policy changes the game entirely. Why would pension funds step into distressed debt markets after they have been told that the EU will, suddenly, no longer stand behind the debt?

The knock-on effects are snowballing. The Irish 10-year bond yield which stood at 7.68% yesterday morning is already above the affordable level for the debt burdened sovereign. The markets realize this, and are voting with their wallets. Anticipating unusual volatility, a clearing house has increased margin requirements for trading in Irish debt. At the same time, non-Eurozone surplus nations are anticipating default and pulling back from funding the weakest European sovereigns. Tracy Alloway posted that Russian documents show that Spanish and Irish bonds are no longer eligible investments for the sovereign Russian National Prosperity Fund in her article The World Backs Away From Ireland, Spain, Portugal on FT Alphaville blog. But the quiet run on Europe’s sovereigns has been going on for some time: the Bank of International Settlements, on page 16 of its September Quarterly Report, states that:

As of the end of the first quarter of 2010, the foreign claims of UK, Japanese and US banks on the public sectors of Germany and France represented 67%, 65% and 57%, respectively, of their foreign claims on all euro area public sectors (Graph 4, centre panel). By contrast, that fraction was equal to only 27% for euro area banks. The ordering of these shares is completely reversed when one focuses on reporting banks’ holdings of higher-yielding euro area government debt (Graph 4, right-hand panel). Euro area banks’ claims on the public sectors of Greece, Ireland, Italy, Portugal and Spain represented close to 54% of their overall holdings of euro area government debt. By comparison, these fractions were equal to 27%, 23% and 20% for US, Japanese and UK banks, respectively.

With the Greek bailout already behind us, and an unavoidable Irish bailout at some point before Ireland needs to tap the bond markets again in February 2011, the numbers above are bound to get more lopsided. Since the crisis broke, hundreds of banks have failed and been restructured in America, yet not a single bank has been forcibly restructured in the Eurozone, even though arguably the European banks were far more overextended going into this crisis. The European solution, instead, was a massive application of “extend and pretend” (or “don’t ask, don’t tell”), which has led to Eurozone sovereigns selling their bonds to Eurozone banks, which in turn receive liquidity from the ECB and the implicit bailout guarantee by the same sovereigns. Europe is a financial house of cards that is teetering at the point of collapse, and Angela Merkel, with her warning that bondholders would have to share some of the pain, abruptly turned the overhead fan knob to the full-on position. If confidence in the bond markets evaporates as a result, the weaker sovereigns will end up at the European Financial Stability Fund for a bailout. Can this fund, which has been called a mere bluff by some astute observers, handle a triple bailout? Or will the bailouts end up being funded by Germany and France, whose banks are mostly on the hook for all this debt?

I share the conclusion reached by Yves Smith at naked capitalism in The Irish Mess (IV):

It will be interesting to see whether and how Merkel resists the pressure when it really comes to it.

The tightrope is getting crowded: not just Ireland, but really, in the end, the whole Eurozone, is on it; and, given the couplings via debt holdings, public and private, the UK, too.

More uncomfortable watching to come.