Last week Mr Jean-Claude Trichet criticized Greece for failing to contain its budget deficit and confirmed the ECB position of not intervening in the matter. He also said that no country should be an exception to the, which implies that if the Greek sovereign credit rating gets degraded to Baa1 (by Moody’s) the European Central Bank will not be allowed to buy any of its bonds. That had an immediate effect on the bond auctions held by the Greek Central Bank in the following days, leading to much higher yields. In Tuesday 3-months bonds traded at 1.67% in comparison with levels of 0.35% in October. Today the CDS prices on the Greek debt rouse to yet another record highs legitimizing forex market concerns about the inability of the new government to cut the country’s deficit to 2.8% by 2012 (according to their recently unveiled plan).

The renewed concerns weighted heavily on the Euro that dipped against the USD. That was hardly bad news for the ECB as they have been struggling to contain the appreciation of the Europe’s currency without lowering their target interest rate. In the battle for competitiveness, European exports have been hampered by the weak dollar and the Chinese peg to the US currency and the bad news from Greece were actually good news for Germany and France. Representing only 3% of Eurozone economy Greek output might be sacrificed for the greater good but the prospect of other countries taking the same road is somewhat frightening (Portugal, Spain, Ireland,Italy for example).

There were raising concerns outside the common market too. Ukraine for example is still on the watch list of potential sovereign defaults, joined by the Baltic states and Iceland. The island nation of just 300 000 people though, just vetoed a law that would have legitimized a $ 5 bn. debt to the UK and the Netherlands sparking Mr Brown’s response. The British prime minister used anti-terrorist law to seize Icelandic property in Britain as a substitute for the unpaid debt. That was a stark reminder of the financial war being waged since the beginning of the global crisis. The Icelandic example might be repeated by other countries in the following months if their public debts raise above what is considered sustainable.

On a long term note, the UK itself does not look financially sound too and neither does Japan or the USA. One of PIMCO’s managers (largest bond fund in the world) recently rated the chance of the UK credit rating being downgraded to 80%. Japan’s budget is in an even dire state since their national pension fund (largest in the world) announced that from 2009 onwards it will be a net seller of Japan bonds. That might signal a looming debt crisis in Japan in the short or mid term especially if the yield on its bonds were to increase.

The obvious dilemma between belt tightening and fighting deflation took its toll as the ex-financial minister Shoichi Nakagawa (56) was found dead in his home in October and his successor Hirohisa Fujii resigned just recently because of alleged health problems. That only spells gloom for the 2nd largest economy in the world that has been running through its savings ever since its economic problems started back in 1989. As of 2009 it seems that even that option is no longer available.

Japan’s financial problems are a symptom of a broader demographic crisis. The ageing population is set to put increasing pressure on the working Japanese and on the economy in general. The USA faces similar problems with the baby boomers starting to retire in 2009. Americas fiscal aches are still far from Japan’s but a political failure to address the issue (totally ignored so far) would cast a shadow over the growth prospect of the USA economy in the years to come.

USA bond yields have already increased expecting Fed’s withdrawal form the market in March prompting an interest rates change in the coming months (currently expected somewhere in the middle of 2010). There are a couple of bumps on the road to recovery envisioned by the current American administration, the most serious one being the decrease of foreign purchases of USD denominated debt. The biggest USA creditor China, was a net seller of American debt in 2009 and the two other major players (Japan and the UK) significantly decreased their purchasing. Hardly surprising after the deficits experienced by those two countries.

A historic view of public debt levels after financial crisis shows expansion of up to 70%. This crisis does not prove to be any different but debt increase of such levels might be a fatal blow for some countries that are already deep in debt. The usual suspects are – Ireland, Greece, Dubai, Portugal, Ukraine, Italy, Spain, Baltic states and in a few years UK, Japan and even the USA (even though some of the states might already be on the way to bankruptcy – California, Arizona, Illinois). This may be a good time to short bonds. And here is a short summery of the Fannie and Freddie situation and some doom and gloom for Japan…