Calm before the storm?

The next crucial date in the Euro zone saga will be the 17 of June when Greece goes to the polls to effectively decide if they want stay in or out of the Euro. Greece might be a small player in the grand scheme of things but the role of market psychology is a multiple of this and is therefore what really matters.
A Greek exit could have severe repercussions on the rest of the Euro zone as it has the potential of triggering a serial bank run in a number of countries in which the banking system remains weak and for which the future European Stability Mechanism (ESM) is poorly equipped to handle. The uncertainty is huge and very palpable with Treasury and German Bund yields that are at record lows.
It seems that no degree of assurance by authorities can suffice to put minds at ease as there is so much that could go wrong and there are signs that things are actually getting worse.
As markets become more convinced that the situation is actually worsening, the sentiment will just accelerate the process of disintegration, like with a vacuum cleaner where the closer you get to the tip, the stronger the sucking power becomes. We currently see this phenomenon with Spain and its banking sector which is experiencing a sharp rise in bad loans, triggering a downgrade in credit rating which in turn is making it more difficult for the country to borrow. This is, after all, what pushed countries like Ireland and Greece to seek external help in the first place and although the European authorities and the IMF still have money to spare in their coffers, contagion will eventually make a bailout impossible, triggering a crisis the likes of which have not been seen since the 1930's.
I don't want to sound too alarmist, but as any good practitioner will tell you, it is important to think of all possible scenarios, starting with the worst one.

The high cost of being risk averse...

In these tumultuous times, compounded by a brewing crisis in the Euro-zone, demand for investments that have traditionally provided shelter from the damages of more "volatile" and "uncertain" times are on the rise. This phenomenon is especially observable in bond markets, at least for those sovereigns that are not perceived to be "drowning" in their debt.
As a matter of fact, the uncertain times, which is behind the strong demand for "safe" government bonds has created a situation where risk premiums have turned negative. This is because as nominal yields have dropped steadily, inflation has remained constant or is even rising, depending on which figures you use.
Take treasuries as an example. The average rate of inflation calculated by taking the consumer price index figures (CPI) from 1914 to 2011 amounts to about 3.25%. If we subtract this from the nominal yield rates of treasuries, the real yield turns out to be negative. The more worrying part of this observation is the fact that real yields are negative throughout all maturities which means that even if you were to hold 30 year treasuries, your return would be expected to be negative (the purchasing power of your capital will be shrinking every year!).
Negative yields are a boom for borrowers because it means that they can borrow very cheaply. The cost to the investor, however, should be an incentive for them to take on more risk, especially in an environment where returns are getting increasingly hard to come by. This is not happening and pundits that have been forecasting an end of the rally of bonds since 2007 have been consistently proven to be wrong. Not enough investors are moving their money out of treasuries to make yields go in the opposite direction. This could be reflecting sentiment that is highly bearish regarding the future which is not surprising when we look at the way in which the sovereign debt crisis is being handled in Europe.

From bad to worse?

The austerity measures in Europe are starting to bite but not in the right way. As governments impose painful belt tightening measures, recent statistical figures  provided by Eurosat, are pointing to a further bloating (degradation) of debt to GDP for the majority of Euro zone members. That certainly does not bode well, considering that the objective of austerity in the first place was to reduce the debt, not increase it! It could be the result of growing deficits and very weak or negative growth. It could also be that there is a sort of lag effect at play and that, over the longer term, there will be a positive impact on the debt. If this the case, it necessitates time to work, or patience, a commodity that respective governments are rapidly running low on. Country after country, the authorities are switching to crisis mode as the public become more vocal regarding their displeasure on the way things are being handled. Union is giving way to nationalism and the harmony of the past is disappearing.
Europe is in trouble, that we know, but maybe more worrying are the signs that things may be getting worse.

Changes in govt debt to GDP ratio, Q311 - Q411 (Eurostat)