With the now infamous picture of him ogling President Christina Fernandez de Kirchner in mind, it’s ironic that the end of the leerer might coincide with the return of the lira. Today we have the unique situation whereby a member of the G7 rich country club is unable to find anyone other than a multilateral central bank willing to own its sovereign debt.
Italy’s 10-year bond yield has shot through the 7% mark, with even its two-year yield at the same level.
Italy has the third largest bond market in the world so this marks a new stage in the ongoing European crisis and has negative implications for global financial markets.
Eurozone economies needed to get worse
Our investment view has been that things would have to get worse to prompt action from central banks and other policymakers to outflank the euro area crisis and the impending recession on the continent. With Greece having opened up the possibility of leaving the euro area, and Italy now unable to find private sector buyers of its bond market, things have definitely got worse.
The only solution to the euro area problem is for the European Central Bank (ECB) to buy government debt as aggressively as necessary to lower yields. But apart from the various hurdles that the ECB has to jump before it can do this (the biggest being getting tacit approval from Germany that it’s OK), things have now deteriorated to the point where the ECB’s actions, should they come, will likely not be enough to avoid a potentially deep recession in Europe.
There is a world of difference between what the ECB will have to do and what the Federal Reserve and Bank of England have done. A central bank buying government debt that is trading at historic low yields, and which investors are happy to own, is quantitative easing and has been an effort to stimulate activity by pushing private investors into doing something other than buying government bonds.
Hopefully that ‘something’ will provide a boost to economic activity. The Bank of England believes QE1 here boosted activity by about 1.5%. When the ECB buys Italian government bonds it is now buying distressed debt. That is likely to avoid Italy falling into a depression, but that is not the same as attempting to generate positive economic growth. Indeed, it is the exact opposite of what the Fed and the Bank of England did; the ECB would be trying to encourage people to buy government bonds!
Clear and present danger
The threat to the euro area is now tangible. French government bond yields are up 11 basis points in a single day and the spread with German bunds is now up to 1.45%, its widest in modern European history. If the market starts to roll on from Italy to France then we really do have a problem.
So, in my view, markets will be very challenged until we know what the response is going to be. There must now be a chance that we get a co-ordinated response from global monetary authorities.
The ECB, the Federal Reserve, the Bank of Japan and the Bank of England, perhaps even joined by the People’s Bank of China, may decide that the threat to the political and economic stability of the euro area is now great enough to justify a co-ordinated buying of euro area debt.
If that happens, the bulls will run rampant. Until it does, keep those bear claws on.
