The strong countries at euro region, mainly Germany have two options:
a) Let Greece and Portugal go bankrupt. In that case, much like what happened after Lehman brothers was left to under, the implicit grantee of the rest of the PIIGS will be questions and their bond will probably tumble causing a full blown physical crisis across the euro area. My guess is that under that scenario government bonds across the world will tumble, excluding the U.S, Germany and other relatively stable countries with possible serious problems in the European banking system. In that case with Israeli government bonds falling sharply the stock market will be no exception with major sell offs across the board.
b) Bailout Greece. In that case German government bonds will come in to question since they can't possibly bail everybody out.
c) Massive devaluation of the euro which seems unlikely since there needs to be probably a 50% or more devaluation in order to counter deflationary forces in the PIIGS.
We are early 2008 all over again. When the sub prime crisis hit in late 2007 the Federal Reserve started to inject liquidity in to the system and slash interest rates. The immediate response of markets was to sell the dollar and take commodity prices to the moon, with oil hitting 147 dollars a barrel. At some stage, the central planners where worried about the rising food prices and the fed stopped slashing interest rates and the ECB even raised them a bit. The lack of liquidity caused the markets to collapse in late 2008. Only when the FED resumed the money printing, this in much larger scale did markets recover with oil hitting 86 dollars a barrel. Since the 31st of March 2010 the FED stopped printing money the lack of liquidity caused the dollar to strengthen and brought a liquidity crunch in Europe. The ECB has taken the FED's place with steroids. It is now buying not only AAA paper like the FED did it is buying junk bond in Greece and across Europe. This effectively will turn the euro in to the Drachma. Today the short Euro+ stocks is reversing and the Euro is rising as a result. But that will not change the big picture- If the ECB continues to print money like crazy the Euro will crash and commodities will go throw the roof. At some stage the ECB will be forced to stop and then the Euro will fall apart.
Another point to remember is that unlike Bernanke Trichet can't buy sell these bonds back into the market since no one in his right mind will buy these bonds at the price Trichet bought them. The ECB has no mechanism to take this liquidity out once it is in the system.
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