Italy, too big to fail or too big to save?

Tom Tong10/Nov/2011Currency Updates

Note: our FX forecasts for EUR, GBP, USD, CHF and JPY are now published on Bloomberg. If you have a terminal, you may access them by typing FXFC.

We continue our series of special reports on the Eurocrisis. We are looking forward to the day when it will be worthwhile again to report on events outside Europe. But for now, there is very little going on outside the continent that is having any impact on financial markets. We are back to the full “risk on / risk off” correlation-one trading environment, and the driver of world financial markets is the Euro – more specifically, the exploding yields on Italian debt.

We left off last week after reporting on Mr. Draghi’s surreal performance at the ECB press conference. His refusal to increase the ECB’s role in financing European sovereigns, and his blithe dismissal of the growing danger of a disorderly Greek exit, amounted to a full declaration of war on financial and economic reality. To paraphrase Hiro Hito’s words in 1945, that war’s situation is developing not necessarily to Europe’s advantage. Purely political measures (unity Government in Greece, Berlusconi resignation in Italy) are having no effect. Italian bond yields soared today to distressed levels, far above 7%. More ominously, the Italian yield curve is starting to invert, a sure sign that markets are pricing in increasing chances of a near-term restructuring, and liquidity is thinning out. These are roughly the markets conditions that prompted the bailout of Greece, Portugal and Ireland. Unfortunately, the EFSF does not have near the firepower to do the same with Italy in a credible way. Only the ECB does, and it refuses to do it. Fortunately, there is increasing evidence that this view is slowly seeping into the conventional wisdom. In this vein, we strongly agree with and recommend the reading of Martin Wolf’s piece in today’s Financial Times:

Not surprisingly, the Euro lost over 3 full figures, and is now flirting with the 1.35 psychological level. Equities around the world are getting clocked, with financial stocks leading the way. The dollar is once again acting as the last remaining safe haven, since both the CHF and the JPY are being effectively held in check by their respective monetary authorities, and gold is actually struggling in this environment – a sign that it
had become more of a speculative plaything than a safe haven lately.

Spanish debt is holding up better than Italian bonds, though it too is struggling. We think that the next front of the crisis could well open up there. The market is not paying enough attention to the upcoming general elections, on November 20th. There will almost surely be a change of Government, and it is likely that the new Administration will want a fresh start by publicizing whichever ugliness is hidden in Spanish data as soon as possible in order to blame the previous Government.

We insist that the only lasting solution to the crisis means an unlimited funding guarantee from the ECB for the distressed sovereigns of Europe, perhaps in return for a sizable loss of fiscal sovereignty for the latter. We still expect the ECB to come to its senses and acknowledge reality. Our main concern is the damage that will have been done to European business, financial and consumer confidence by the time it does. Until then, we consider that current levels in the Euro against most other currencies are much too high.

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Written by Tom Tong

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