Montreal, Canada

Germany failed to auction a 5-year bund or bond yesterday marking the first time Europe’s largest economy has scrapped an auction since several issues failed to go to market back in October 2008 at the height of the credit crisis. Spain, Italy, Greece and Portugal are also struggling to sell paper this month with the former requiring European Central Bank (ECB) purchase assistance over the last ten days to raise short-term financing.

Increasingly, the odds of a European sovereign bond default is growing as markets put enormous pressure on regional bond financing amid renewed credit strains in LIBOR. Since mid-May, European banks have grown reluctant to lend to one another in overnight markets and instead are hoarding cash again at the ECB.

The poor reception of the German note on Wednesday could signal a new phase in the ongoing sovereign credit crisis in Europe as investors balk at government paper – including those regarded as the highest quality. The only country in the euro-zone seemingly able to sell its bonds without ECB assistance – including a 30-year note last week – is the Netherlands. France has also successfully secured required financing.

The Germans went to market yesterday offering the lowest yields in almost 20 years. The five-year tranche was offered at a bid of 1.47% compared to 2.20% on a similar auction a month ago. The auction failed when institutions pulled out of their initial offer, thereby reducing the amount of bonds they were willing to purchase. Germany subsequently scrubbed the auction.

In October 2008, Germany and Austria failed to sell short-term paper and scrapped several large auctions. Yesterday’s failed German bond auction might be a harbinger of more bad news for capital markets. If Germany can’t sell paper – easily regarded as Europe’s safe-haven country despite its bulging deficits – then what lies next for investors?

According to Bill Gross of PIMCO, the best bond fund manager in the world, a Greek default is imminent. Such a scenario would plunge European markets into total chaos and smash regional banks with loans to Greece -- mostly German banks.

In a world marred by currency drunks harboring deteriorating budgetary fundamentals, the recipe for arresting high debt-to-GDP ratios in the euro-zone is austerity. While austerity reduces deficits it also encourages deflation or a protracted economic environment of falling prices and weak final demand. The euro-zone is heading in this direction.

Spain, Ireland, Greece and Italy have all recently taken their bitter fiscal medicine to reduce bloated deficits; but it seems highly probable that markets will suffer a massive jolt again this summer or fall as one or more sovereign nations eventually defaults on their debt obligations. Greece is likely to be the first domino to fall.