The Numbers That Show Italy Needs A Bailout

Published in Investing on 9 November 2011

Yields on Italian government debt reach danger levels, threatening the euro zone.

Forget about company fundamentals. Ignore the UK's economic statistics. The only thing driving stock markets this year is politics and, to be specific, euro-zone politics.

The PIIGS problem

So far in 2011, it's all been about the PIIGS of Europe: Portugal, Ireland, Italy, Greece and Spain.

In a series of sharp zigzags, share prices have swung wildly as hope and fear have alternately gripped investors. Indeed, as I pointed out earlier this month, the FTSE 100 index of elite British companies has been unusually volatile this year.

Late last week, stock markets headed south because of 'Papandamonium' caused by the decision of Greek Prime Minister George Papandreou to hold a referendum on his country's latest bailout. Within days, Papandreou made an abrupt about-turn and is expected to step down shortly as leader.

This week, share prices were lifted by a 'Berlusconi bounce' from Italian Prime Minister Silvio Berlusconi's promise to resign after seeing through Italy's latest austerity package. As a result, the Footsie rose a little over 1% yesterday.

Mr Bond strikes back

Although political leaders do keep an eye on their national stock markets, the real power behind financial markets is wielded by so-called 'bond vigilantes', who manage tens of trillions of dollars in bonds.

When these investors in government and corporate IOUs lose their cool, all hell can break loose. Hence, James Carville, political advisor to former US President Bill Clinton, once dryly remarked:

"I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody."

This morning, bond investors made their feelings about Italy very clear, as they sold Italian government bonds by the lorry load. As a result, Italian bond prices plunged, driving up yields on these fixed-income investments to record highs.

The Italian sell-off

As I write, the yield on the 10-year Italian bond has leapt to nearly 7.36%, up nearly 0.6 percentage points in less than 24 hours. Earlier today, this yield peaked at more than 7.48%, which is a record high since the euro zone was established in 1999. In comparison, ten-year German Bunds yield a tiny 1.73%.

Furthermore, Italy's one-year bond yield is also showing signs of severe stress. It currently stands at 8.15%, which is almost eight percentage points above the 0.24% yield offered by one-year German Bunds.

Frankly, at these levels, bond investors are pricing in a 'haircut', which strongly suggests that Italy will have to seek some kind of bailout from the European Union and the International Monetary Fund. Indeed, when bond yields for fellow PIIGS Portugal, Ireland and Greece surpassed 6.5%, these countries admitted defeat and passed around the begging bowl.

Then again, at €1.9 trillion, Italy's bond market is vastly bigger than any other in Europe. What's more, Italy has to roll over at least €360 billion of this debt next year, which it simply cannot do at current yields.

Hence, it looks like the game is up for Italy and it will have to 'do a Greece'.

Otherwise, bond investors will panic, selling weaker bonds and fleeing to the relative safety of safer securities such as US Treasuries, German Bunds and UK Gilts. When bond investors seek safety, government with weak finances and outsized debts -- such as Italy -- take a beating.

What next?

Tom Paterson, chief economist at gold broker Gold Made Simple, warns:

"The sovereign-debt crisis continues unabated and, in short order, has claimed two more prime ministerial scalps... Italy’s borrowing costs have risen to unsustainable levels and the country now runs a serious risk of being swamped by its debts. At these levels of risk, no-one is going to want to take on Italian debt... 1,600 years from the first Sack of Rome, some Italians are seeing Barbarians at the gate once again."

"It's sobering to remember that just one year ago, Italy's borrowing costs were perceived as low. Some commentators even suggested that this proved Italy was fine and should borrow even more. Now those same commentators are saying the same about the UK and its borrowing costs. But Italy’s current pain highlights just how quickly things change -- the UK has been warned."

After Italy, which will be the next domino to fall? Will it be Spain, as many are betting on, or will the UK fall foul of bond investors? Let's hope David Cameron and George Osborne can keep Mr Market's confidence until growth takes off again!

More from Cliff D'Arcy:

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UncleEbenezer 09 Nov 2011 , 1:48pm

A fine buying opportunity for someone.

But not one I'm going to try and time!

UncleEbenezer 09 Nov 2011 , 1:52pm

Should've added: actually I do hold some Italian debt, by virtue of holding Invesco Perpetual bond funds, whose managers see Euro-debt volatility as an opportunity. I expect lots of us have this kind of indirect exposure.

vinchainsaw 09 Nov 2011 , 2:02pm

This reminds me of a safari, with predators picking off the weakest of the herd one by one.

NeilW 09 Nov 2011 , 7:43pm

They'll line them up in order from Greek to Germany until the ECB gets over its indigestion problem with setting the bond interest rate by buying anything that yields more.

The only way out of this problem is a sustained ECB broadside.

duffmanchon 09 Nov 2011 , 9:33pm

Cliff, truth is UK could borrow more to invest in infrastructure which would boost our GDP and help cut the deficit. If the bond markets turned against us we have the BOE to step in. Unfortunately for the italians they don't have the luxury of printing their own money. Osborne won't borrow more as he's lashed himself to the mast ideologically and is now desperately looking at spending in other ways i.e. credit easing.

AdamB1978 10 Nov 2011 , 10:36am

I think the key line in that article is the description of the bloke at the bottom 'chief economist at gold broker Gold Made Simple'...he doesnt have a vested interest in fanning the flames at all does he???

CunningCliff 10 Nov 2011 , 10:47am

Note that the market for Italian bonds is the third-largest in the world, after the US and Japan. Yikes!


drfuzz 10 Nov 2011 , 11:19am

Personally I'm surprised it has taken so long for the markets to home in on Italy. The situation has been unsustainable for a long, long time.

This is a confirmation of what we pretty much new; a bit like with bank runs, the loss of confidence is enough to make the siutation a self fulflilling prophecy.

This should be a huge warning to all European countries including the UK and the US; get your public finances in order or subject yourself to a self fulfilling prophecy of speculation.

I would speculate Ireland will be the next problem. Despite all the cuts, the country is running a huge deficit to go with its equally huge debt levels and a bit of speculation pushing up the rates will lead to an Italy situation. But after that I fear we are looking even closer to home... Belgium, France and the UK.

Ultimately, I think we are looking at the end of our lovely European social systems which have been the cause of our debt. Better get used to working till you drop and paying extortionate prices for healthcare like the remaining 9/10s of the world....

pickepics 10 Nov 2011 , 2:02pm

It seems to me the bond markets have made their decision and the EZ will follow quite rapidly by their standards. There are two possibilities:

1. German politicians wake up to the fact that their outstanding performance in recent times is down to what is for them is an undervalued euro and get behind the ECB to prop up Club Med to give them time to sort themselves out. Time is needed for them to do that and they must be given the breathing space, albeit under strict and strictly policed conditions. German politicians need to sell that to the German voters. A very tough task.

2. The Germans dig in for a little while too long. The Italians and Greeks (at least) fail and leave the EZ and massively devalue the new lira and drachma. The whole of Europe's financial system takes a serious battering and the rest of the world doesn't come off much better.

In either instance life goes on. We have several dark financial days to live through but at least it all seems to be coming to a head. I'm hoping it will all wash through within 6 to 18 months.

CunningCliff 10 Nov 2011 , 5:12pm

I heard on the radio or TV that Italy's national debt has risen in 38 of the past 50 years. Nice budgeting, signori!

Also, I don't think Italy has been hit by 'speculators' or 'vigilantes' as such.

In truth, I suspect that cautious bond managers and investors have been selling down their Italian holdings hand over fist. This would account for the steep fall in Italian bond prices yesterday.


BarneyCowshed 11 Nov 2011 , 4:13pm

Is it to soon to start worrying about France.

pickepics 11 Nov 2011 , 11:33pm

We've worried about France for a thousand years and more. Why stop now? You'll only have to start again in February (6 nations).

Cliff, the fall in bond prices was a rise in interest rates for Italian bonds. Watch what happens to them on Monday if Belusconi doesn't resign on Saturday!

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