FYI | Nov 10 2011
Kathleen Brooks, Research Director UK EMEA, FOREX.com
The silence from the EU’s high command as Italian bond yields come under sustained attack is deafening. It’s been left to UK PM David Cameron, head of a party with a vocal Eurosceptic faction, to come out and say that any nation leaving the Eurozone would be “very painful” for the UK, but also for the global economy. The markets are unlikely to give up their attack without some major action from Brussels today, and it is unlikely that another emergency summit will suffice.
Italian 10-year yields hit 7.48% earlier, nearly 70 basis points higher on the day. There is blood in the streets of the Italian bond market and this is starting to spread to other assets markets. EURUSD is sinking towards 1.3600 – nearly 250 pips below its high reached in the Asian session, and after a strong start European stocks are firmly lower. The moves in the FX market are extremely significant. 1.3600 is a key support level and the bottom of the most recent range for EURUSD, below here opens the way back towards the 1.3200 lows we witnessed back at the start of October.
However, this time the market is extremely short euro according to the latest data on speculative positioning from the CFTC. Short euro positions have recovered slightly since the start of October, but remain back at mid-2010 lows. This suggests that further declines may not be as sharp as we have seen in the past since so many people are short the single currency already. But as we said earlier, it is no surprise that the euro and other risky assets have come under pressure as Italy has gone to the wall.
But how will this problem be solved? These are worrying times for Italy, even after Ireland had announced large budget cuts and public sector lay-offs its bond yields continued to rise forcing it to seek a bailout, so Italian bond yields could move further even if Italy manages to get another government in place and implements fresh austerity reforms. Although Italy hasn’t formally asked for help, these bond yields are totally unsustainable and it is unlikely that tomorrow and Monday’s scheduled bond auctions will take place since Rome cannot guarantee that there will be willing buyers. The EU and IMF have sent representatives in to try and enforce fiscal reform, which is a bit like the diet-bailout option; however this isn’t placating the markets.
Although the ECB is rumoured to be in the markets buying Italian and Spanish debt, the effect is minimal. At one point today 2-year bond yields were higher than 10-years; however, short term debt has since retreated, possibly suggesting the ECB is buying the short-end of the Italian curve. The problem is that the EU doesn’t have a plan to support Italy, which is weighing on market confidence. The EFSF isn’t any bigger than it was in June when it was extended to EUR440bn and it is unlikely that cash-rich sovereign funds will want to invest in the current environment especially when the EU wants to implement a 50% haircut on holders of Greek debt and Italy is so close to bailout.
The situation is critical, and if it is to be stabilised the ECB is going to have to step in to provide unsterilized support – i.e., become the lender of last resort. However, new ECB President Mario Draghi explicitly said that the ECB can’t prop up Europe’s bond markets because it is not in its mandate. The EU’s leaders may have to act pretty quickly to change the Treaty if they want to prove to the markets they have the Italian situation under control. However, at this stage the ECB as financial back-stop is a political hand grenade, especially for Germany.
We are still waiting to hear who the next leader of the Greek government will be, and at the time of writing the two weakest links in the Euro-area are leaderless. Thus, there could be a mini-rally if the politics get sorted out, but the market smells blood and is looking for some major action from the EU sooner rather than later.
Elsewhere, China’s weaker inflation data had little impact on the market even though it makes it more likely that China could start to loosen monetary policy, which should be good news for the region. The Aussie is being driven by risk appetite and AUDUSD is below 1.0200 at the time of writing, the next support is 1.0150, but if this panic in the market continues then we could see parity once again.
French budget deficit figures for September were better than expected, however, UK trade data was much weaker than expected in September and August’s data was revised lower. The US Treasury is set to auction $25 billion of debt today, in the current environment it is hard to see how investors wouldn’t suck up this US debt, especially since Treasuries are the safe haven of choice at the moment.
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