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Is a Greek default inevitable?

Things are getting worse. There are also signs of contagion to other fiscally-weak countries in Europe.

Here is the latest development from WSJ that traders are betting Greece will eventually default.

Greek bond prices posted a drastic decline Thursday as traders began betting a debt default is inevitable, even if the country receives a massive bailout.

The Greek bond market is now priced for a "catastrophic event," says Sebastien Galy, senior foreign-exchange strategist at BNP Paribas.

Greece's woes helped sink the euro to an 11-month low before the common currency recovered some of its losses.

Although conditions in the Greek bond market have generally been deteriorating over the past several weeks, Thursday's session saw an especially steep decline in short-term debt prices. As a result, the yield on Greek two-year notes jumped to more than 12% from 8.3% Wednesday, according to Tradeweb.

At those levels, the prices are suggesting that "even if [Greece] finds a solution, if you buy two-year bonds, you may not be getting all your money back," says Mark Schofield, global head of interest-rate strategy at Citigroup in London.

Meanwhile, yields on 10-year Greek bonds rose to 8.92%, almost six percentage points over comparable German debt. That gap is the widest since Greek joined the euro zone. Just two weeks ago, that spread stood closer to four percentage points.

The backdrop for the selloff was still more bad news for Greece. The European Union's statistical authority said Greece's 2009 budget deficit was worse than had been previously reported, and politicians in Germany ramped up their opposition to a Greek bailout.

Meanwhile, Moody's Investors Service downgraded Greece's debt rating and warned that additional cuts could be on the way.

The woes in the Greek bond market also are spilling over to other European nations with fiscal problems, such as Portugal, Spain and, to a lesser extent, Italy. Traders say the selloffs in those markets to some degree reflect a sentiment that bond prices in those markets hadn't been reflecting the poor fundamentals of those countries.

For much of April, even as the Greek bond market began to collapse, prices on the other Mediterranean countries' debt had been relatively stable. On April 1, for example, the gap, or spread, between German and Portuguese two-year debt stood at less than 0.6 percentage point, almost the same as U.S. Treasury debt.

But in the past week, the Portuguese spread has risen sharply, hitting 1.83 percentage points Thursday from 0.83 percentage point a week ago. Spain's two-year spreads widened 0.82 percentage point Thursday from 1.38 percentage points Wednesday.

'We're seeing contagion," says Citigroup's Mr. Schofield, who noted that the impact of Greece was also being seen in a widening between the prices at which bonds could be bought and sold. "I don't think those countries are an immediate default risk to the same extent as Greece … but these are countries where the fiscal backdrop is very poor."

With financial markets focused on the prospect of a debt default by the Greek government, the International Monetary Fund fretted aloud this week about the prospects for a sovereign-debt crisis, focusing on Europe.

In a report this week, the IMF said Portugal, and to a lesser extent Spain and Italy, would be the most likely to suffer from contagion if Greece goes over the edge.

IMF's contagion analysis noted that Ireland, in the line of fire a year ago over its own fiscal woes, would escape the worst of a Greek default. Investors appear to believe Ireland has acted pre-emptively and decisively to get the deficit under control, analysts noted.

To avoid Greece's plight, says Uri Dadush, a former World Bank official now at the Carnegie Endowment in Washington, Italy too should move aggressively to cut its budget deficit by a further 4% of gross domestic product over three years, and engineer a 6% real devaluation through wage cuts and economic reforms.

"I think the broad policy recommendations have general applicability in Spain, too," he said.

On Thursday, the damage from Greece also spread to the currency markets, where the euro slid as low as $1.3257, its lowest level since May 2009. By day's end the euro had rebounded slightly and was changing hands at $1.3314, from $1.3399 Wednesday.

BNP's Mr. Galy says one potential silver lining is that many European banks may have reduced their exposure to Greece.

"Risk managers seem to have hit the panic button on anything that was left," he says. "That's good from a systemic point of view."

Many investors say there are just too many headwinds for Greece to overcome, and that even a bailout won't be an end to the crisis.

"The problem is likely going to come back in 2011 and 2012," says Michael Hasenstab, manager of the Templeton Global Bond Fund. "You get in this vicious cycle, and it's a very difficult situation."

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