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Eurozone pulls back from the brink

This chart gives an overview of the current state of 2-yr yields in the PIIS countries (I exclude Greece because there appears no hope of avoiding a significant default, with 2-yr Greek yields trading at about 120%). One thing stands out, and that is the recent decline in yields on Italian and Spanish debt. They have pulled back from the 7+% brink (France down about 100 bps from its recent highs, Spain down 130 bps), but they are still elevated. Both countries appear serious about controlling spending and reducing their deficits, but it will take a long time to convince skeptical investors that these countries have really changed their spendthrift ways. Eurozone 2-yr swap spreads have only declined marginally, from a recent high of 115 bps to 109 bps today; Europe is still facing enormous challenges.

The chart above shows that 2-yr French yields have sharply reversed, an indication that France remains almost as solid as Germany and is not likely to turn into another Italy. French spreads to Germany had blown out to 140 bps a few days ago, but are now back in to about 75 bps. That is a very welcome improvement, but in a normal world the spread would be close to zero.

Meanwhile, Eurozone equities are up some 15% from their recent lows. This is a palpable sign of relief—a decent pullback from the brink of an awful abyss. But it is probably premature to conclude that conditions in Europe will continue to improve in a straight line from here, even though its tempting to think. As a long-term investor, however, I think it makes sense to bet that the Eurozone economies will eventually do the right thing, and that makes today's equity valuations very attractive.

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