FEARS OF DOMINO EFFECT PERVADE EUROPE

Brusels, November 24- Contagion once again emerged in Europe as investors turned from Ireland”s debt crisis and set their sights on Portugal and Spain.

Both Spanish and Portuguese bond prices fell sharply Tuesday, and the yields above German bunds rose to records. The euro slid below $1.34 for the first time in two months, though part of the weakness came as investors turned to the safe-haven status of the U.S. dollar after North Korean artillery attacks on South Korea.

"People that are betting on contagion are probably making the right bet here," said David Gilmore, a strategist at Foreign Exchange Analytics. "There”s not really anything to stop the markets from pushing the next domino over”.

The unease over Europe, combined with the events in Korea, spread to U.S. markets as well. The Dow Jones Industrial Average slumped 142.21 points, or 1.3%, to 11036.37.

Asian markets were down in early Wednesday trading, with Japan”s Nikkei Stock Average down 1.5%, South Korea”s Kospi down 2%, New Zealand”s NZSX-50 down 0.3% and Australia”s S&P/ASX 200 down 0.6%.

Prices of Treasurys, typically seen as a haven investment, jumped.

Highlighting the concerns about European financial markets, German Chancellor Angela Merkel called Ireland”s crisis "very worrying" for the region.

The sudden turn in Europe has caught many traders off guard.

The focus in recent weeks has been on the impact of the Federal Reserve”s easing measures. And at the tail end of last week, many investors had assumed the Irish situation was on its way to being resolved. But with the unraveling of Ireland”s coalition government Monday, contagion is back on the minds of investors.

Ireland”s request for a bailout from the European Union and the International Monetary Fund followed government capital injections to prop up banks that suffered big loan losses. This has turned the spotlight to banks in Spain and Portugal.

Meanwhile, Portugal reported on Monday that its 10-month budget deficit widened from a year ago. Tuesday, Spain issued short-term debt at a significantly higher cost than a month ago.

"I think that”s the market”s realization; that these are systemic problems that are going to need a systemic solution," said Brian Yelvington, fixed-income strategist at Knight Capital. "This is not a one-off problem with an individual country”.

Rising spreads have hit one country after the other, moving from Greece to Ireland and now to Portugal and Spain.

The worry is that those rising borrowing costs eventually may prove prohibitive, forcing countries to seek some sort of bailout.

Contagion, broadly defined as when a loss of market confidence in one economy transmits to others, can occur through trade connections, economic similarities or financial linkages. An economic downturn in one country can hit its trading partner”s exports or reduce tourism revenue.

A collapse in value of financial assets in one country can hit confidence about banks in another if those banks hold a lot of those assets.

A second source of contagion is where investors look across from a troubled economy and see similar problems elsewhere.

While Portugal doesn”t have banking problems of the scale of Ireland”s or a budget deficit as big as Greece”s, it does have a combination of budget deficits, high government debt and low growth that worries some investors.

A third transmission mechanism for contagion is through investor portfolios, in which price declines in one asset class cause investors to sell other assets.

Particularly noteworthy is the focus on Spain. Tuesday, the gap between German and Spanish bonds rose 0.30 percentage point overnight, to 2.36 percentage points, the highest since the euro was introduced in 1999, well above the previous record of 2.21 percentage points set in May, according to RBC Capital Markets.

That selloff is notable because while Greece, Portugal and Ireland are facing significant fiscal and economic woes, those economies are relatively small. Bailouts of all three are seen as manageable.

But should Spain fall into a death spiral, where its interest payments rise so much that the country can”t afford to borrow, a bailout is seen by many in the markets as impractical and more likely to require a restructuring of debt that would inflict losses on bondholders, many of whom happen to be European banks.

Traders said those banks likely were among those selling either Spanish, Portuguese and even Italian bonds Tuesday, as well as buying insurance against default by those countries as a hedge.

For hedge funds and other money managers, figuring out how best to trade in the turmoil has been complicated by several factors.

Some they are hesitant to make big speculative bets through the market for credit-default swaps, because trading in Portuguese and Spanish swaps is relatively infrequent. That makes buying and selling much more difficult. Credit-default swaps act like insurance, protecting bondholders in the event of a default.

There also is a concern among hedge funds that there could be government bailouts, which could affect how CDS trade.

Instead, some managers are looking to trade the debt of financial companies in countries such as Ireland and Portugal by betting that some of that debt will fall in price.

It also is harder to place bets against the euro, now that the Federal Reserve is pumping the financial system with money.

In fact, rather than betting on a decline in the euro, many traders had been leaning the opposite direction leading up to the recent turmoil, holding short positions in the dollar and owning euros.

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