Italy next in line to test debt market

2012-04-20 15:50

London - Italy’s borrowing costs are under pressure to rise further at a bond sale next Friday because investors are nursing renewed doubts about whether highly-indebted euro zone governments can get their finances under control.

Five days is a long time in the euro zone crisis and the market mood may swing sharply, but the auction has been singled out as a central “risk event”, watched not only by bond investors but by most people involved in global financial markets.

After Italy and Spain sold debt with ease earlier this year, riding a wave of cheap European Central Bank loans to commercial banks, the euro zone’s third and fourth biggest economies are feeling the heat again.

The main worries revolve around Spain’s ability to control its budget deficit without choking an economy still burdened by bad debts from a property bubble that burst four years ago. Its banks could yet require a government bailout.

Such risks stoke the pressure on Italy, whose public debts are among the heaviest in the world at 1.2 times its annual economic output.

Spanish 10-year yields are flirting with 6 percent - not unsustainable in itself, but a level that courts fears of a debt spiral.

“When yields are above 6 percent in Spain, it is dangerous. There will be a lot of attention on the auction,” ING rate strategist Alessandro Giansanti said.

Details of the auction are yet to be announced. Italy usually sells medium- and long-term bonds at this time of the month.

The bearish market may prompt the Treasury to concentrate on selling shorter-dated debt, on the grounds that investors will be more nervous about lending over longer periods.

But using such a tactic over any length of time would risk swelling the amounts of debt repayments coming due again in the next few years.

With all these worries in mind, investors are likely to seek cheaper bonds prices at the auction. This could push 10-year Italian yields up to 5.80-5.85 percent next week from 5.65 percent on Friday, Monument Securities strategist Marc Ostwald said.

If the auction results disappoint, the market could soon test 6 percent again.

“It is not a complete panic at the moment, the auction will be covered, but I would expect yields will rise. Higher and higher financing costs is more bad news for Italy than it is for almost anyone else,” said Investec fixed income analyst Elisabeth Afseth.

The dog house

The increased focus on Spain and the relative credibility of Prime Minister Mario Monti’s economic management skills made it easier for markets to accept a tiny increase this week in Italy’s 2012 budget deficit target.

But investors remain wary that key labour reforms aimed at boosting Italy’s low economic growth potential could be significantly altered in parliament. A disappointment on that front would make it more costly for Italy to sell its debt.

“We’re still pretty much at the first hurdle in terms of structural reforms,” Monument’s Ostwald said.

“If Monti fails the first hurdle, markets will put Italy back in the dog house and Italy would become a contagion factor for Spain rather than vice versa.”

Increased risk aversion might bode well for Wednesday’s sale of ultra-long German debt, which is seen as one of the safest financial instruments in the world. However, 30-year yields trade within an inch of their record lows of 2.337 percent, and that may hurt demand.

Although financing poses no worries for euro zone powerhouse Germany, the country does struggle to find buyers for its debt from time to time when the returns on offer fall too low. Last week a 10-year Bund auction attracted less in bids than the amount on offer.

“The danger of a failed auction is greater for Germany than in Italy,” Investec’s Afseth said.