Italian Debt Woes and Their Implication for the Euro

Last week saw a dramatic ramping up of the eurozone crisis as Italian Bond yields surged by 0.5%. While this may not seem much, when taken into the context of the lowering of German yields after payroll, the shift is worrying. Italy’s pre-monetary union typically had yields of plus 10%, but for the last 10 years has been trapped in a broad sideways pattern. This has seen yields top out at around 5.75%. The risk is that with yields now touching 5.40%, any further attacks and breaches of the top of the range could see an exponential move that targets 7.25 and 9.3%.

Over the past weekend, the Italian regulator imposed restrictions of short-selling. They stopped short of an outright ban, but insisted that any major positions must be reported. The history of regulators or politicians intervening and trying to manipulate a market up is disastrous. In the height of credit crunch, the banning of short selling banks led to an almost instant collapse. They fail to realise the liquidity short sellers provide and the fact that they must fund the position. It can be very expensive if they are wrong. The removal of liquidity is what causes the falls and this feeds on itself as buyers withdraw as well.

On 11 July, the euro came under severe pressure. The chart shows the breach of a major trend line support, but it is on the cross rates that the real damage is being done. While I still perceive the Swiss franc’s safe haven status to be grossly overdone, against currencies such as the Singapore dollar, we are only now entering an accelerated downward trend. However, there are currencies that are faring even worse than the euro. The Polish zloty is actually falling against the euro and is severely weak against the US dollar. This highlights how swiftly contagion can spread and means treasurers need to be fully aware of all the peripherals.

Figure 1: Euro Outlook Breaks Trendline Support

Source: CQG



Related reading

Mark Carney Bank of England