By Colin Barr
June 22, 2010

The flight to quality is taking off again.

Demand for U.S. government bonds is so strong that a $40 billion auction of two-year Treasury notes Tuesday cleared at a record low yield, Reuters reports. The sale comes on a day when the yield on the 10-year Treasury dropped to 3.19%, marking their lowest close in two weeks.

Government bond sales are drawing lots of buyers in part because the global economic recovery is looking wobbly, as is the U.S. housing market. There, forecasts of a double-dip in house prices are multiplying. Another drop stands to mean more foreclosures and bigger losses for U.S. lenders.

But the bigger driver is the fear that cash-strapped European governments won’t make good on their financial promises. Derivatives traders were betting Tuesday there is a better than 50% chance Greece will default on its bonds within five years, according to CMA data.

Meanwhile, the annual cost of insuring against a default on bonds issued by the Spanish government surged 14% Tuesday to $250,000 for every $10 million worth of debt, CMA said. That approaches the levels credit default swaps on Spanish debt traded at during last month’s Greek panic.

Yet as ugly as Spain’s fundamentals appear to be, the bigger risk probably lies in Portugal, according to one line of thinking. With French and German banks up to their eyeballs in exposure to Spain, tough-talking European policymakers are likely to give in and bail the Spanish government out should push come to shove, Wisconsin professor Mark Copelovitch writes.

The same, he contends, goes for Ireland, given the massive exposure of U.K. banks to its teetering economy. Recognizing these interests puts the loose talk of profligacy and thriftiness in a decidedly different light, Copelovitch writes.

How would-be rescuers act depends less on the behavior of the borrower, he writes, than “on their own domestic financial interests and the vulnerability of their own commercial banks to a potential financial crisis.”

Of course, policymakers aren’t about to admit this, so we can look forward to months of denial as the outlook for a Europe recovery fades and investors get even more nervous. Lower yields, here we come.

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