Italian bond auction no success story

Risk has come off since the Italian debt auction. Although the debt was sold, including €1.25 billion of five-year bonds, the yield Italy had to pay to investors took a massive jump. Five-year bond yields rose to 4.93 per cent from 3.9 per cent at an auction in June.

While the auction will most likely be spun as a success, there are some worrying signs and Italy won’t be able to continue to have debt auctions like this indefinitely. For example, the yield on the 15-year debt it sold was just below 6 per cent and the amount of debt auctioned was lower than anticipated to limit the risk the auction would fail.

These last minute measures smack of desperation. Although the European Central Bank is not expected to have bought Italian bonds in the secondary market this morning there were rumours that Bank of Italy officials had staged a charm offensive to major banks and financial institutions to ensure they participated in the auction. This doesn’t fill the market with confidence that Italy will be able to continue to sell its debt without problems in the capital markets.

Italian bonds have given up some of yesterday’s gains, and yields are back at 5.65 per cent. EUR/USD had a fairly muted reaction to the auction. It was trading as high as 1.4225/30 earlier, but has since dropped below 1.4200.

The balance of risks to the single currency is lower for the rest of this week in our opinion. Firstly, the Italian auction was no great success; secondly, Italy is set to hold a parliamentary vote on new budget measures later today. Although this is set to pass, Italy’s government would be wise to step up their programme of fiscal consolidation in the current environment. Added to this, European bank stress tests are also released tomorrow at 1700 BST, after European markets close. This could spark a pre-weekend sell-off in the euro in our opinion.

While EUR/CHF is taking the brunt of investors’ fears about the Eurozone, the single currency looks fairly well supported against the dollar after credit rating agency Moody’s threatened the US that its debt rating would be cut if the debt ceiling was breached. It appears like sovereign debt concerns are broadening beyond Europe. Japan, the US, the UK are also coming under the microscope now that investors are becoming less tolerant of huge debt piles, even for large economies.

The debt warning coupled with Ben Bernanke’s testimony to the House of Representatives; today he addresses the Senate, weighed on the dollar overnight. Although Bernanke said the risks to the economy seem to be balanced, the markets have run with his comment that the Federal Reserce stands ready to provide more stimulus if necessary. We still think that the bar is high to QE3, but the Fed will be pragmatic in its response to a slowdown in growth.

Economic data is becoming more important to gauge the strength of the recovery in the developed countries. Today’s CPI data out of the Eurozone came in line with expectations at 2.7 per cent, although core prices rose to 1.6 per cent from 1.5 per cent in May, so even though prices are subdued, pressures are still noted at the bottom of the pipeline.

In the US today’s retail sales figures are expected to show weaker consumption last month and the market is expecting sales to have remained flat. This may confirm that household spending slowed sharply in the second quarter and could weigh on sentiment.

It’s been fairly quiet in the UK; next week’s minutes from the last Bank of England meeting and the first reading of Q2 GDP on 26 July will be key indicators and will determine the direction of sterling for the medium-term.

Another theme that is developing is central bank intervention in the currency markets. Both the Swiss franc and the Japanese yen have strengthened sharply as the Eurozone debt crisis has flared up. The Swiss Central Bank’s Jordan suggested that intervention wasn’t entirely off the table to stem Swissie strength and that he was “very worried” about developments in Europe. Likewise, rumours have been circulating that Japanese officials were actively buying dollars in an attempt to stem yen strength after USD/JPY took a dive below 78.50 at one stage after the Moody’s announcement on US debt.

Kathleen Brooks is research director at Forex.com

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