The European Central Bank admitted earlier today that it had taken part in asset purchases intended to give lift to the Italian debt markets. Through the week ending November 4, the ECB says it spent $13.1 billion to push down Italian yields against other European governments.
The action wasn’t enough to cool investors’ concerns that the European economy as a whole may be in a stage of complete meltdown. Today, two-year German government bonds (Bunds) fell to find a yield only seven basis points higher than an all-time low. Meanwhile, yields on Italian government debt skyrocketed.
The ten-year Italian bond fell to yield 6.67% to maturity, a clear signal from investors that the Italian bond is quickly growing its risk-profile. German Bunds with similar maturities traded with yields 4.9% lower, even though both countries operate on the same currency—the Euro. Clearly, investors believe that the risk for default in Italy is very high, regardless of a Euro-specific plan from the ECB to bail out most of the continent’s failing governments and banking systems.
Ten-year government bonds are one of the most important debt issues in finance. Financiers look to government securities to price everything from corporate debt sales to mortgages, automotive loans, and other financing agreements. As the 10-year yield rises higher and higher, the size of Italy’s deficit grows as interest charges on debt grow exponentially, while consumers are straddled with higher and higher interest rates for consumer financing agreements.
Rising rates would dramatically affect government balance sheets. Calculations from the Bank of Italy suggest that a 1% rise in interest yields would remove .2% of economic productivity from GDP. After a 3% hike in rates, as much as 1% of GDP is immediately removed from the economy, the result of higher interest costs to both government and consumers.
The risk for default is priced into any financial security, especially debt obligations. As trading came to an end on Monday, the CDS market reflected larger costs of insurance against sovereign debt exposure. Even Germany, which has perhaps the most productive economy out of any EU nation, experienced a rising price for insurance on its 5-year Bunds.
Another triple-A rated nation, France, saw one of the biggest leaps in the cost to insure its debt issues. The private market has long expected France to surrender its triple-A rating following rising deficits, plunging economic output, and renewed concern that indebted nations could swing the whole Eurozone economy into recession. Credit default swaps sell for 100 basis points more than German CDS derivatives, a clear indication that the country is perceived to be twice as risky as another triple-A rated country.
A loss to France’s triple-A rating will be merely a psychological event. The markets have already priced insurance on French debt in the same way one might price risk on riskier investment-grade bonds. To compare the US and France, the United States’ 5-year Treasury sells at a yield to maturity of .86% annually, less than the cost of insurance alone on French debt securities.