by Calculated Risk on 12/16/2011 02:36:00 PM

European bond yields have fallen recently ...

The Italian 2 year yield is down to 5.29% - the lowest level since October, and the 10 year yield is at 6.59%.

The Spanish 2 year yield is down sharply to 3.46%, and the 10 year yield is down to 5.31%.

But there are plenty of negative headlines:

From the Financial Times: EFSF considers euro warning clause (ht Brian)

In the latest draft of the prospectus, seen by the Financial Times, a summary of the dangers to investors includes: “[R]isks arising from a Reference Sovereign ceasing to use the euro as its lawful currency . . . or the cessation of the euro as a lawful currency”.
excerpt with permission

That would be quite a warning clause.

And here is some downbeat testimony from Deputy Assistant Treasury Secretary Mark Sobel today: What the Euro Crisis Means for Taxpayers and the U.S. Economy

The European Economic Outlook is Weakening
Over the past year, economic and financial stresses in Europe have spread to some of Europe’s largest economies, and the crisis now facing Europe is deeper and more entrenched. Sovereign bond yields have risen sharply in many countries. Many European financial institutions have faced difficulties in obtaining funding from markets and are de-leveraging in order to strengthen their capital adequacy. European equities have fallen by a quarter since April.

These developments have resulted in a sharp weakening in Europe’s current growth performance and significant markdowns in growth projections for 2012. Growth in the euro area is projected by most analysts to be negative this quarter and into early 2012, with weak growth persisting in 2012. For example, the OECD, which earlier this year had projected annual average European growth in 2012 of 2.0 percent, just revised its estimate to 0.2 percent. Many private forecasters are more pessimistic.

Europe’s problems are a serious risk for the U.S. outlook
In the United States, the pace of recovery has strengthened recently and most analysts expect continued moderate growth next year. But given Europe’s strong trade and financial linkages with the rest of the world, other regions could feel the impact as well. Indeed, Europe’s problems are a serious risk for the U.S. economic outlook.

• The European Union buys nearly 20 percent of U.S. goods exports ($242.6 billion in 2010) and over 30 percent of U.S. service exports ($170.2 billion). The European Union accounts for 63 percent of the stock of foreign direct investment (FDI) into the United States, at $1.5 trillion, and 56 percent of new investment in 2010. Therefore, when European growth slows, U.S. jobs, exports, and FDI inflows decline.

• Global financial markets are strongly interconnected. When European financial markets tighten, it can adversely impact U.S. banks’ confidence and their willingness to lend and invest. That, in turn, can hurt American businesses and jobs, particularly in smaller firms that depend on credit from their banks to grow and innovate.

• When EU stocks decline, U.S. equity markets often do as well, hitting the savings and wealth of Americans.

To make these linkages more concrete, for instance, exports to the European Union represent over 24, 20 and 18 percent, respectively, of merchandise exports from New York, North Carolina, and Illinois. In each of these states, over 150,000 jobs – and over 250,000 in Illinois – are export-related. A decline in exports to Europe will inevitably adversely impact America.

And there is some evidence of tightening. The TED spread is increasing and is now up to 56.8 (This hit 463 on Oct 10, 2008), and the two year swap spread is up to 49.5 (This spread peaked at near 165 in early October 2008). Still not too bad.

From the WSJ: Fitch Affirms France as AAA, Warns on Six Others

Fitch Ratings lowered its outlook on France's triple-A rating to "negative" from "stable," indicating there is a 50-50 chance the nation could lose its top investment-grade rating over the next two years.
...
The ratings firm also put on downgrade watch several investment-grade-rated euro-zone nations that already had a negative outlook. In addition to Italy and Spain, that action snared Belgium, Slovenia, Ireland and Cyprus. Fitch said it expects to complete the review by the end of January. It said it would likely downgrade the ratings by one or two notches.

And there is a rumor of an S&P downgrade of France after the market today.