Daily Market Reports | Nov 10 2011
By Greg Peel
The Dow fell 389 points or 3.2% while the S&P dropped 3.7% to 1229 and the Nasdaq lost 3.9%.
Financial markets had remained relatively calm over the escalation in the European crisis which has brought Italy into the spotlight, if one makes comparisons to the August-September period which was all about Greece. Either the general feeling was that Italy's problems could be resolved, particularly with the resignation of Silvio Berlusconi, or perhaps markets were simply trying to convince themselves everything would be okay. That all changed last night.
Last night international clearing house LCH Clearnet decided it was overexposed to potentially volatile Italian sovereign debt and thus decided to increase the margins on bond trading. It was no small increase – margins on 7-10 year Italian bonds rose from 6.65% to 11.65%. We often see such margin increases in commodity futures, such as in copper and silver in recent times, which were once considered more volatile than sovereign debt. But the bottom line is if you can't afford the new margins on the positions you're holding, you have to reduce your positions.
The timing may have been necessary, but is otherwise very unhelpful. In short, the margin increase alone saw Italian ten-years cross the line at 7% last night to be trading at 7.25%. It was at this point each of Greece, Ireland and Portugal conceded to the IMF that a bail-out was required. Add up the debt of all three, then multiply by 2.7, and you have Italy's debt at E1.9trn. It is estimated the bail-out fund for Italy would need to be E1.4trn. At this stage the plan is to leverage up the EFSF to E1trn.
And there is no one in the world prepared to lend money to the EFSF. Recent small bond auctions held by the Facility have met with minimal demand. China was meant to be interested earlier on, but Beijing has since decided to pump fresh capital into Chinese banks instead in a move that seems to imply Beijing is preparing for the worst. The EU has ordered Italy to get its act together before any consideration of financial assistance – just as it did with Greece (which, incidentally, still has no prime minister) – leaving the IMF as the only potential source of funds. But the IMF is funded by contributions from members, the largest of which is the US. Somehow the concept of America handing over billions to Italy right now via the IMF at a time when its own debt ceiling remains an issue, and elections are nigh, seems a remote one.
Were there no euro (and again, we're right back where we were earlier with Greece), the IMF could move into to Italy and force a major devaluation of the lira, thus substantially reducing the real value of Italy's debt through inflation. But there is a euro, so that is not possible. Alternatively the ECB could print euros and give them to Italy, but the ECB's only mandate is to control eurozone inflation. Euro printing would fly in the face of this one mandate, and already other eurozone members are very upset at the ECB's purchases of Italian sovereign debt, which they see as illegal under the charter. It is also considered simply “unfair” to call on the funds of frugal members to prop up the over-indulgent members.
There have thus been calls to rewrite the powers and responsibilities of the ECB – something France has been keen on (given the amount of sovereign debt held by French banks). Germany is dead against this idea, as well it might be as the most significant end-lender by implication, so it isn't going to happen.
In relation to all of the above, there were two interesting sets of comments made last night – one by Sarcozy and the other by Merkel. Sarcozy made a passing remark in which he suggested a “two-speed” Europe. Observers took this as a hint of a possible move towards a first division and a second division for the euro. Merkel, on the other hand, made an impassioned speech in which she called for an even more united Europe – a fiscally united Europe in which national budgets are determined by a central body and penalties are imposed on any member breaching budget limits.
Both speeches, while somewhat diametrically opposed, imply that the current eurozone cannot continue to exist as it is. And well might that be the case. The eurozone was ill-conceived, has been very poorly managed, and has shown to have been a failure. It's time is nigh.
Which is pretty much how markets were reading the situation last night.
The Italian president is now desperately trying to shift next week's parliamentary budget vote forward to Friday. He also wants elections to be held before Christmas, rather than next year as Berlusconi has suggested. Were the budget to be passed on Friday, or at least soon, this would go some way to appeasing markets, as would Berlusconi's promised subsequent resignation. But Berlusconi's resignation does not guarantee his successor has any better chance of dealing with Italy's problems.
The irony is that Italy doesn't even have a budget deficit at present. Unlike Greece, its debt has not been getting bigger every day. The simple fact is that Italy is carrying too much debt already at E1.9trn and with E300bn due to be rolled over in 2012 a borrowing cost in excess of 7% would imply Italy would be illiquid.
The euro fell 2% against the US dollar last night, sending the dollar index up 1.7% to 77.91. The Aussie fell 2.4 cents to US$1.0152 while gold did its best to fight back against the big move up in the dollar, falling US$18.70 to US$1765.70/oz.
Base metals all fell 1-3%. Brent fell US$3.17 to US$111.91/bbl and West Texas fell US77c to US$96.03/bbl.
The yield on the US ten-year bond fell 12 basis points to 1.96% as an offset to yield increases in Europe. The VIX volatility index jumped 32% to 36.
It had been a good day for Australia yesterday – consumer confidence was shown to have risen and the Chinese CPI was shown to have fallen to 5.5% growth in October from 6.1% in September. The SPI Overnight is down 102 points or 2.6%.
It's unemployment day in Australia today, and we'll see China's monthly trade balance. SingTel ((SGT)) posts an interim result.
Rudi will be on Sky Business today at 12pm at which time he can address the question: what happens now?
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