July 12, 2011 6:53 pm

Italian and Spanish bonds feel heat as contagion fears rise

Volatility returned to the eurozone markets with a vengeance this week. Italian and Spanish bond yields have gyrated, bank stocks have swung wildly, while the euro has tumbled against the dollar.

The rising uncertainty briefly sent Italian and Spanish yields for 10-year bonds above 6 per cent – levels last seen in 1997 – and has prompted demands for further action from policymakers to stabilise the markets.

Italian and Spanish yields

Some strategists even warn that the eurozone project could break up unless action is taken quickly.

Willem Buiter, Citi’s chief economist, says: “The crisis has moved to the broad periphery or the soft core of Italy and Spain. We are talking of a game-changer and a systemic crisis. This is existential for the eurozone.”

Harvinder Sian, euro rates strategist at RBS, says: “If yields on Italian and Spanish bonds go above 7 per cent, then this will not just be a eurozone crisis, it will be a global crisis, threatening the currency club in its existing form.”

Speculation that the European Central Bank is prepared to purchase Italian bonds combined with a relatively successful debt auction in Rome, with China a rumoured buyer, stemmed the sell-off on Tuesday, but investors and strategists fear more topsy-turvy days in the markets, not helped by Italian prime minister Silvio Berlusconi’s weak coalition government.

On Tuesday, Italian bond yields hit intra-day highs of 6.01 per cent before dropping back to about 5.5 per cent, while Spanish yields rose to 6.30 per cent before falling back to about 5.8 per cent.

Italian banks UniCredit and Intesa Sanpaolo saw their shares open sharply lower before witnessing a big recovery. The euro also fell to a four-month low against the dollar before recovering.

More worryingly, even France, at the core of the eurozone, has seen increasing volatility in its debt markets. French credit default swaps, which offer a form of insurance against default, jumped to 124 basis points, or $124,000 annually to insure $10m of debt over five years, before settling back to about 100bp.

The most immediate danger of further volatility is from Italian bond auctions on Thursday. Unless the ECB is willing to buy Italian bonds ahead of the auction as it reportedly did for Portugal in mid-January, the risks of a poor debt sale and further sharp market swings are high, say investors and strategists.

Indeed, the volatility has prompted an increasing number of market participants to step up calls for a greater role for the European Financial Stability Facility – the eurozone rescue fund – in shoring up the markets to fill the gap left by the ECB, which is clearly reluctant to restart its bond buying programme.

Mr Buiter says the EFSF, which has the capacity to lend €440bn to struggling governments currently, should be increased in size to €2,000bn.

He calls this the “bazooka” option and says it would ensure there was enough money to bail out Spain and Italy.

Other market participants want the scope of the fund to be increased to allow it to buy bonds in the secondary market, taking over the role from the ECB.

There was some hope on Tuesday that policymakers might act quickly to bolster the EFSF after eurogroup finance ministers said they were considering enhancing the flexibility and scope of the fund, lengthening the maturities of the loans it offers and lowering interest rates for the countries being bailed out.

Lower interst rates on EFSF loans would help bailed out countries as the eurozone rescue fund’s oans become an increasingly large part of the outstanding debt of the bailed out countries.

Other measures that investors and strategists say should be considered soon are buy-backs of Greek bonds to lower the overall burden of Athens’ debt. This could be done by allowing the EFSF to buy back Greek debt or permitting the fund to lend to Athens to buy back its own debt.

Another measure that could stabilise the crisis, say strategists, is the introduction of a European version of the US’ Troubled Asset Relief Programme or Tarp, which bought assets and equities from financial institutions to help them recapitalise.

However, such measures may take time to implement. Mr Sian says: “Contagion is here. We are seeing Spain and Italy get hit. There is very little time. As we have seen in the past, bond yields can lurch higher very quickly. Ideally, the ECB would start buying Italian bonds to help stabilise the markets, but that seems unlikely.”

Bill Blain, senior director at Newedge, a futures broker, fears that policymakers will fail to respond to stem the uncertainty. “We are heading for the break-up of the eurozone. Politically Europe won’t accept never-ending fiscal transfers,” he says.

Nicholas Spiro, head of Spiro Strategy, a consultancy, says: “The problem is one of confidence in the eurozone markets. The EU authorities hold the key to restoring this confidence by taking the right measures. That is very worrying.”

The rising uncertainty briefly sent Italian and Spanish yields for 10-year bonds above 6 per cent – levels last seen in 1997 – and has prompted demands for further action from policymakers to stabilise the markets.

Some strategists even warn that the eurozone project could break up unless action is taken quickly.

Willem Buiter, Citi’s chief economist, says: “The crisis has moved to the broad periphery or the soft core of Italy and Spain. We are talking of a game-changer and a systemic crisis. This is existential for the eurozone.”

Harvinder Sian, euro rates strategist at RBS, says: “If yields on Italian and Spanish bonds go above 7 per cent, then this will not just be a eurozone crisis, it will be a global crisis, threatening the currency club in its existing form.”

Speculation that the European Central Bank is prepared to purchase Italian bonds combined with a relatively successful debt auction in Rome, with China a rumoured buyer, stemmed the sell-off on Tuesday, but investors and strategists fear more topsy-turvy days in the markets, not helped by Italian prime minister Silvio Berlusconi’s weak coalition government.

On Tuesday, Italian bond yields hit intra-day highs of 6.01 per cent before dropping back to around 5.5 per cent, while Spanish yields rose to 6.30 per cent before falling back to around 5.8 per cent. Shares of Italian banks UniCredit and Intesa Sanpaolo saw their shares open sharply down before witnessing a major recovery. The euro also fell to four month lows against the dollar before recovering.

More worryingly, even France, at the core of the eurozone, has seen increasing volatility in its debt markets. French credit default swaps, which offer a form of insurance against default, jumped to 124 basis points, or $124,000 annually to insure $10m of debt over five years, before settling back to around 100bp.

The most immediate danger of further volatility is from Italian bond auctions on Thursday. Unless the ECB is willing to buy Italian bonds ahead of the auction as it reportedly did for Portugal in mid-January, the risks of a poor debt sale and further sharp market swings are high, say investors and strategists.

Indeed, the volatility has prompted an increasing number of market participants to step up calls for a greater role for the European Financial Stability Facility – the eurozone rescue fund – in shoring up the markets to fill the gap left by the ECB, which is clearly reluctant to restart its bond buying programme.

Mr Buiter says the EFSF, which has the capacity to lend €440bn to struggling governments currently, should be increased in size to €2,000bn. He calls this the “bazooka” option and says it would ensure there was enough money to bail-out Spain and Italy.

Other market participants want the scope of the fund to be increased to allow it to buy bonds in the secondary market, taking over the role from the ECB.

There was some hope on Tuesday that policymakers might act quickly to bolster the EFSF after eurogroup finance ministers said they were considering enhancing the flexibility and scope of the fund, lengthening the maturities of the loans it offers and lowering interest rates for the countries being bailed out.

Other measures that investors and strategists say should be considered soon are buy backs of Greek bonds to lower the overall burden of Athens’ debt. This could be done by allowing the EFSF to buy back Greek debt or permitting the fund to lend to Athens to buy back its own debt.

However, such measures may take time to implement.

Mr Sian says: “Contagion is here. We are seeing Spain and Italy get hit. There is very little time. As we have seen in the past, bond yields can lurch higher very quickly. Ideally, the ECB would start buying Italian bonds to help stabilise the markets, but that seems unlikely.”

Bill Blain, senior director at Newedge, a futures broker, fears that policymakers will fail to respond to stem the uncertainty. “We are heading for the break-up of the eurozone. Politically Europe won’t accept never-ending fiscal transfers,” he says.

Nicholas Spiro, head of Spiro Strategy, a consultancy, says: “The problem is one of confidence in the eurozone markets. The EU authorities hold the key to restoring this confidence by taking the right measures. That is very worrying.”

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