Despite the cheer and salute by the market to the agreement reached by European politicians yesterday, in the light of a new day, concerns emerge. Not only do market participants need further details and clarity about the path forward for Greek writedowns, bank recapitalization, and leveraging up of the EFSF, as well as swift implementation by Euro-zone countries of the Summit's goals, we continue to be concerned about the path forward for Italy.
We saw that concern come through in Italy's bond market as it auctioned off new debt and had to pay its steepest price in the euro area.
From FT: The cause of the renewed tension in the bond complex is Rome's €6bn auction of 3-, 8- and 11-year notes. The sale illustrated how the country is having to pay through the nose to raise money as investors remain wary about its finances.
The March 2022 BTP had to be sold with a yield of 6.06 per cent - that's a euro-era high - compared to 5.86 for an equivalent bond last month.
As you can see today's debt auction caused Italy's yield on its 10-year to climb from below 5.9% to 5.966% as of 8AM ET. The 6% level is extremely important because if yields climb too much above that it becomes quite unsustainable for Italy to service its debt load.
The last time we got near the 6% level it created a firestorm in the markets and causes the European Central Bank to expand its bond purchase program from the bailed out countries - Greece, Ireland, and Portugal - to the 3rd and 4th largest countries in the euro zone - Italy and Spain. In order to secure that help from the ECB Italy had to propose austerity measures to bring its debt load under control, but since then we had seen backsliding which hurt investor confidence.
The ECB intervention that occurred in early August, with further though more limited support in the following months, has now mainly been undone as yields in Italy again approach the 6% level. The Italain Prime Minister Silvio Berlusconi, with his control on government hanging by a thread, is being pressured to push through further austerity (and growth) measures by Germany and France. Obviously as you can see from yields the last two months the bond vigilantes agree that more needs to be done or they will demand a higher premium to buy Italian debt.
The whole need for a larger, more leveraged EFSF comes from the fact that European politicians want to contain the spread of contagion from reaching Italy, as a bailout of Italy would seriously overwhelm any bailout funds. The hope is that the extra support provided by the EFSF would keep Italy from going down that road.
While the image above is a little dated, it gives us a good picture of what's at stake. The Italian debt load dwarfs that of Spain, Greece, Portugal, and Ireland.
Therefore despite the euphoria over the agreement yesterday in Brussels the pressure, and the focal point for the future of the sovereign debt crisis, remains the same - Italy. We'll see the response of the ECB to this recent climb in yields and whether the incoming ECB president Maria Draghi - who headed the Bank of Italy - will try and extract further austerity measures before committing to further significant bond purchases to ease these yields.
If yields continue to rise then the euro will have a hard time expanding on its gains from this week, and with the prospect of the ECB lowering interest rates as a result of the weak macro data pointing to the possibility of flat or negative growth in the euro zone in the coming quarters, the possibility of a EUR/USD retracement to the October rally grows.