Markets take a breath after morning sell-off

What looked like a bloodbath this morning has eased off a little as we progress through the European session. Pressures continue to mount for both Italy and Spain. At one point Italian bond yields surged to 6 per cent, and Spanish yields looked like they were heading towards the critical 7 per cent mark. However, rumours suggest that the European Central Bank (ECB) stepped into the market and bought Italian debt, which has taken the edge off Italian bonds causing the yield to moderate to 5.8 per cent.

The Eurogroup Finance Ministers’ released a statement last night that the market is taking as a step in the right direction to finding a resolution to this crisis. The first thing the statement stressed was the EU’s ability to stem contagion risk through lengthening the maturity of loans and lowering interest rates. It also suggested that liquidity and loans will be made available to ensure that the banking systems of the weakest member nations (which now includes Italy) are safe.

However, they have so far failed to come up with a final decision on private sector involvement in a second bailout for Greece. Although the ECB is against any type of default, other members of the EU seem to be coming round to the fact that Greece needs to lower its debt burden. Either private investors take the hit or the EU authorities’ step in and suck up some of Greece’s liabilities. Once investors know if they have to take the hit or the EU will act as the backstop in any financial crisis, then investors will be happy to buy the bonds. Markets hate uncertainty and a lack of clarity on this point has led to contagion rippling through the larger economies of Europe.

Italy is obviously the most pressing problem. On Thursday Italy has a large auction planned for long-term debt. As we have mentioned before, it has €175 billion of debt set to go to auction this year alone (part of its massive €1.6 trillion debt burden). Today it sold one-year short term bills. The debt was all sold, however, the bid-to-cover ratio was weaker and compared to an auction in June and interest rates were much higher at 3.67 per cent versus 2.14 per cent last month.

You can see that this level of financing cost is not sustainable for the long-term. In a sign that efforts are being made to reign in Italy’s public debts, finance minister Giulio Tremonti has left the finance ministers’ meeting in Brussels to return to Rome.  Expectations are growing that a parliamentary vote on fiscal consolidation measures will now take place earlier than expected.

Italian politicians now need to show a firm commitment to reducing debt and getting on to a path of fiscal sustainability. Italy’s long standing fiscal weaknesses have come into focus, however, the markets may be cheered by the news that Italy’s leaders seem to be reacting to the pressure in the bond markets. This has eased some pressure on the euro, which is back above 1.3900 against the dollar and 110.00 against the yen.

We are still in an environment where safe havens should perform well. The EU releases its comprehensive bank stress test results on Friday and they are already attracting concern. Firstly, rumours are circulating that six Spanish and Italian banks have failed and will need to recapitalise. Secondly, a German banking association has criticised the timing of the release of the tests saying it will only exacerbate tensions in the markets. These comments aren’t exactly going to fill investors with confidence, especially since they would rather know the worst case scenario when they go to price in risk.

But as some commenters have noted, the sharp decline in bond yields across the currency bloc will indeed exacerbate the situation and increase the amount of capital some banks (especially those exposed to lots of sovereign debt) will need to raise. But if they don’t include sovereign debt at current market prices then the tests won’t be taken as credible.

If the EU does decide to delay the release of the tests this may only create more volatility in the markets as investors assume that the there is something bad to hide.

At the moment there is some good news coming from China. Arguably it is the only nation with pockets deep enough to save the euro if Spain and Italy were to require a bailout. Last night the People's Bank of China deputy governor said that he has confidence in the single currency.

Elsewhere, the pound came under pressure in line with other risky assets; however the moderation in price pressures in June also caused a brief bout of investor selling. Headline CPI fell to 4.2 per cent from 4.5 per cent in May, and core inflation fell even more sharply to 2.8 per cent from 3.3 per cent in May. While this is still above the Bank of England’s target rate, it suggests the Bank won’t be pressured into rate increases if growth remains stubbornly weak.

Inflation in France and Germany remained in line with expectations, and the Bank of Japan kept rates on hold as expected.

Overall, the markets focus is still on Europe, Spain and Italy as expected. This will continue to weigh on stocks and boost safe havens until firstly, we see a breakthrough on how private investors will be involved with a Greek default and secondly, signs that Italian politicians will deal with their debt load. We are not convinced that the recent pullback in risk is a sign that the worst is over, it may just be the calm before the storm.

Kathleen Brooks is research director at Forex.com

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