The euro zone sovereign debt situation continues to weigh on the euro. Earlier this week we saw Germany fail to sell the maximum amount that a bond auction and in a subsequent press conference held by German Chancellor Angela Merkel she ruled out support for euro bonds.

width=384From Bloomberg: German Chancellor Angela Merkel again ruled out joint euro-area borrowing and an expanded role for the European Central Bank in fighting the debt crisis.

Euro bonds are not needed and not appropriate, Merkel said today at a press conference with Italian Prime Minister Mario Monti and French President Nicolas Sarkozy in Strasbourg, France. She said euro bonds would level the difference in euro-region interest rates. It would be a completely wrong signal to ignore those diverging interest rates because they're an indicator of where work still needs to be done.

In the same conference, with France's Sarkozy and Italy's Monti by her side, Merkel announced a plan to change EU treaties in order to enshrine automatic sanctions and debt brakes in a closer fiscal union.

But with no clear and easy short-term solutions for the sovereign debt crisis at hand, the markets continue to worry about strains on periphery funding costs, and we saw that borne out by Italian borrowing costs yesterday and today.

Italian 10-Year Yields Above 7% for Second Day on Weak Auction

width=571

Italy was again in the crosshairs as it's 10-year yield climbed above 7% yesterday and Italian bonds extended their losses, and thereby saw a yields pushed even higher, in today session.

The catalyst here was a poor Italian debt auction:

From Financial Times: Italy's borrowing costs shot higher on Friday as Rome was forced to pay euro-era high interest rates to investors in what analysts called an awful auction of short-term debt.

Friday's sale came at a much higher cost to Italy's treasury than previous sales, as investors demanded a yield of 7.814 per cent on the two-year bond, up from 4.628 per cent at the previous sale of this maturity in October. The six-month bill demanded a yield of 6.504 per cent - a euro-era high - up from 3.535 per cent in the October sale.

The poor debt auction, which Italy is paying more than 7% borrow for six months,  will add pressure on the new Italian government to introduce additional budget measures that aims to cut the country's debt load, as well as reforms to the economy to help its growth rate. The rub of course is that any changes will take time to implement and despite how fast Monti and his Cabinet may work, it will take a long time for market confidence around Italy's finances to come back.

What to do during the interim is the main question, and how much more difficult will the job be if euro zone enters a period of strong contraction? Italy does have some time before its soaring borrowing costs begin to have a lasting impact.

From Bloomberg: The soaring borrowing costs won't have a lasting impact on Italy's debt even as the Treasury prepares to sell 440 billion euros of bonds and bills next year, Maria Cannata, director of public debt at the Treasury, said on Nov. 16.

The amount sounds prohibitive, but it's not, even if things have gotten more complicated as investors are frightened by the volatility, Cannata said at a conference in Milan. Italy's first bond redemption comes on Feb. 1, when it must pay back 26 billion euros for debt sold 10 years ago.

The market meanwhile is deciding that the main answer is to dump riskier assets and the Euro, which fell to a 7-week low against the US dollar at 1.3225. It wasn't just against the dollar that the Euro was weaker, as it saw broad weakness in today's session.

Nick Nasad
Chief Market Analyst
FXTimes