Worries over contagion of Eurozone's sovereign debt crisis have materialized and the focus is now on Italy. While Prime Minister Berlusconi agreed to step down, he called for elections instead of formation of an interim government. This might further delay implementation of structural and fiscal reforms. The country's 10-year bond yields surged above 7%, making it impossible to fund its debts by tapping money from the public. Political turmoil in Greece was the same complicated. News said that talks of selecting a new Prime Minister collapsed. These issues have not only dampened market sentiment but also have triggered Germany and France to discuss about exit of some Eurozone countries.
Italy's 10-year bond yields jumped to as high as 7.46% before closing at 7.25%. The situation was exacerbated LCH Clearnet's announcement that it has raised the initial margin call for to Italian debts from 3.5-5% across all maturities. The situation in Greece remained uncertain but appeared more manageable than Italy's.
It was reported that Germany and France have considered letting some Eurozone member exit the bloc. While the 'rumor' was denied, it might not be impossible. At a speech on Tuesday, French President Sarkozy said that a 2-speed Europe was the only model for the future. Without mentioning if the core bloc will be shrink to smaller than 17, Sarkozy mentioned that 'there are 27 of us [in the EU]. Clearly, down the line we will have to include the Balkans. There will be 32, 33, 34 of us. No one thinks that federalism, total integration, will be possible with 33, 34 or 35 states... Clearly, there will be a two-speed Europe: one speed that moves towards more integration in the euro zone and one speed for a confederation within the European Union'. Possible exit of some countries from the Eurozone has added to market anxiety and sent US stocks even lower.
While the focus remained in the Eurozone, the BOE will be meeting today. While we expect no change in monetary policy, i.e. the Bank rate at 0.5% and the asset purchase program at 275B pound, up +75b pound, policymakers will probably hint that further easing is possible should financial market conditions deteriorate further. The expansion last month may not be sufficient to boost the economy which has been vulnerable due to domestic weakness and global economic headwinds.