Two avid investors meet for the weekly exchange of views and news affecting markets. The conversation explores contagion risk and what it means for investment prospects.

Rahul: Hey, thanks for the meet-up. I wanted to ask about this word contagion risk that is being thrown around. Since you are better equipped in markets, can you explain this?

Abhijit: The markets seem to rediscover an older phenomenon once every few years — contagion risk, but this time from yield spikes. The last time this word was bandied about — around 2008 — the whole world was given a “crash” course in global financial systems. Similar to last time, the US caught the cold and Europe has started sneezing. Let us start with France’s yield spike.

France, in its Budget announcement, projected a debt to GDP ratio of 119 per cent. The seemingly-unsustainable debt increase drove higher yields, as investors seek compensation for higher risk of the borrower. This is on top of high inflation from energy prices, which had earlier caused inflation-led yield rise. Finally, the political situation is also not helping; student-riots in France, snap elections in Spain, shifting alliances in Germany and the never-ending Ukraine war are all impacting bond yields.

Rahul: Didn’t US yields spike first?

Abhijit: Yes, US yield spike was the first to break out, but Europe following suit is the quintessential ‘contagion’ part of the risk. The US reasons are roughly the same — high inflation, high government borrowings, but with AI-related debt-raising as a cherry on top. US yields are now eyeing escape velocity at 5.3 per cent for US 10-year bonds. From France, the yield spike has spread to Italy, Spain and Greece whose yields are also spiking in tandem.

Rahul: Will the contagion stop at this level?

Abhijit: If the yields persist at the higher range, all other asset classes will come under strain, including the US or Indian equities. Borrowing costs and existing EMIs will rise limiting growth and demand respectively.

With the safest of assets yielding upwards of 5 per cent, the return expectations from other assets will rise — which implies a market sell-off — one which we are experiencing right now.

So essentially, from the US to France to Europe to India equities, the contagion risk seems to be taking shape.

Rahul: Seems like we have seen this movie before in 2008. How do they compare?

Abhijit: Broadly yes, 2008 crisis started in the US followed by spiked Euro bonds. But details matter. The start of the 2008 crisis is well-known, US sub-prime lending ran into housing market crash, which caused widespread defaults. A credit crisis was born as the US and European banks were the lenders to the defaulted assets.

A credit crisis was more or less finally managed with the government’s backing in both the US and Europe.

But Greece, it turns out, was hiding something bigger. On joining the Euro block in 2001, Greece suddenly found access to ‘never-before’ cheap interest loans. And it splurged like one would expect it to — including the 2004 Athens Olympics. Euro laws dictates a 3 per cent Budget deficit limit, which was ‘managed’ through creative accounting.

Credit crisis reached European mainland at this point in 2008. Investors, looking closely at sovereign debt instruments in times of credit freeze, found significant risks in Greece. Greece’s newly-elected government in 2009 said that the Budget deficit was 13 per cent and not 6 per cent. Greece’s bonds crashed, and then gradually followed by every other European bond with high debt and low growth: Portugal, Ireland, Italy and Spain (PIIGS).

Rahul: What is the contagion part if weak economies are exposed rightly?

Abhijit: The contagion part is when bonds are held by each other, Greek bonds held by commercial banks of France, Germany, Portugal and others which increases the systematic risk.

The credit freeze pushes otherwise healthy entities — countries, companies or small business to harder times which impacts the real economy.

The austerity measures enacted across countries can create a drag on the economies of the countries.

But the real contagion risk stems from the speculative part. Traders get an easy fix — wake up, short a European bond, book profits.

Rahul: Agreed, real economy is easier to deal with than speculative narrative feeding on itself. How did they turn it around?

Abhijit: By 2012, expectations of Euro Block collapse had gained real strength with speculators shorting weaker European economies. But at a routine press conference in June 2012 that turned out to be historical in global markets, Mario Draghi, the then ECB president, said the words “will do whatever it takes” to preserve the Euro.

ECB followed it up with a bond-buying fund – Outright Monetary Transaction fund. With the Central bank as the counterparty to the shorts and a mandate backed by deep pockets to stem the slide, speculative shorting came to a grinding halt.

Interestingly, with not much assistance from the actual fund apparently.

Rahul: Indeed, speculative narratives are fun like that. They come from a shred of truth that gets magnified.

Published on October 10, 2026