Last month’s auction of German bonds failed to attract enough buyers and raised the suggestion that the eurozone debt crisis had reached the gates of Berlin. The bonds that did sell attracted an average yield of 1.98% so this is not quite the first sign of a crisis of confidence in German debt, but is a shot across the bow.

In other news, a small Latvian bank was forced by the Latvian regulator to suspend operations. Long queues began forming outside branches of the bank as depositors waited anxiously to withdraw their cash. The Latvian bank is owned by a larger Lithuanian bank that was recently nationalised to avoid collapse. On the same day, Latvia cancelled an auction of 10-year bonds. Not, claimed the country’s central bank, due to a lack of demand, but because the country expects to receive a credit rating upgrade next year and feels that would be a better time to raise new funds. That may well be the case, but it is not surprising that reporting of these unconnected events speculated about canaries and mines.

Since cracks began appearing in the cast-iron credentials of some of Europe’s core economies and the yields of their bonds began to rise, investors have been starting to reassess the meaning of “risk-free”. After all, the cornerstone “risk-free” investment, US debt, is no longer triple-A rated and the spread between German debt (AAA rated) and French debt (also AAA rated) is currently around 1.5%.

As the weeks grind by and political heads roll, investors are still waiting for signs that the crisis can be resolved because without them, the chances of Europe recovering from this economic disaster quickly are melting away. A quick look at economic signals around the world suggests that all the meaningful downside risk now rests in Europe.

There are faint positive signs from around the globe, but all rely on avoiding contagion from Europe. The global economy has been expanding at a rate close to its long-term trend for the past few months, while unemployment has been moving sideways. Of course, the regional variations within this are huge. Japan is enjoying an economic boost as the process of reconstruction continues and while China has slowed significantly from its recent peak of GDP growth, in relative terms it is still humming.

Some of the data from the US is mixed but in general, it is getting by. The Fed has been buying long-dated treasuries again and some sectors of the bond market are behaving in the way they did on the eve of the 2010 Quantitative Easing program that proved positive for stock markets. If the US can avoid contagion from Europe’s crisis, the outlook for the world’s largest economy could start to improve. And where the US leads, other markets follow. But the best news from around the world is that inflation looks to be peaking.

This is the silver lining in China’s slowing rate of growth and gives central banks room to ease or maintain loose policy. It also helps keep a lid on fuel prices and therefore commercial and domestic costs. This could make a material difference through the winter in the US and Europe.

 Already, lower petrol prices through October are thought to have provided a boost to last month’s US retail sales. The worry for anyone watching Europe closely is that there are echoes of the summer of 2007 and the start of the credit crunch when the interbank market dried up and banks lost faith in one another. With memories of 2007 fresh in trader’s minds, there is the risk of a self-fulfilling loop forming which could go something like this:

1. The fear of losses on sovereign debt leads to funding for governments and banks drying up.
2. This triggers another credit crunch as banks stop lending and because governments cannot afford to borrow more from the markets, they are forced to introduce more austerity.
3. This, combined with the lack of available credit, chokes the economy and the consequent loss of national income leads to
4. Fear of losses on sovereign debt. Let’s hope this is avoided.

Though it is virtually impossible to overstate the significance of the eurozone crisis, elsewhere in the world, with inflation falling, central banks will ease policy until growth recovers. How long that might take is anyone’s guess. In 2008 there were about nine months between the peak of inflation and the trough in growth. In 2001 it was more than two years.

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