Market Overview

Italy Needs an Offer it Can't Refuse

Everyone and their brother was euphoric yesterday, as equity markets acted like Europe had solved its problems overnight.

Sorry to be the bearer of bad bad news, but it did not. There were no concrete details on how the European Financial Stability Facility (EFSF) will be leveraged, how the European banks will be able to raise capital, and if the contagion from Greece will stop in Greece, or spread to the other "PIIGS", especially Italy.

It looks like that might be already happening. Italy had a three, six, eight and ten year debt auction this morning that was nothing short of atrocious. After the resolution yesterday, the yield on Italian ten year debt fell below 6%, but stayed healthily above 5%, causing some confusion for many investors and money managers, who felt it should have gone below 5%. Today's auction had a yield above 6%. This signals that nothing is fixed, especially in Italy, as there is weak demand for government debt. Italy was supposed to raise €8.5 billion through the auction, and raised far less.

The borrowing costs on ten year debt are over 6 percent for the first time since the Euro was launched. At the European Summit, Prime Minister Silvio Berlusconi promised austerity measures and certain reforms to help bring government spending under control, but Italy can not operate its government paying 6% on ten year debt.

That is unsustainable in the long run, and if problems happen in Italy, it will be bigger than anything we have seen so far. The spread between Italian and German debt is 378 basis points, the widest it has ever been. We could see a bailout of Italy faster than many would like to believe if this keeps up. With the third largest debt market in the world, at almost $2.5 trillion, Italy needs serious help, or it could default. The EFSF has anywhere between $250-$440 billion in it currently. Plans are for it to be leveraged up four to five times. That would mean a leveraged EFSF would be around $1 trillion, perhaps a few hundred billion more depending on the true size of the EFSF and the amount of leverage used.

If China is brought in to help contribute to the EFSF, that could calm fears a little, but that does not mean Italy can help its debt servicing costs be brought down sharply. The difference between Italy and the two other largest markets, the U.S. and Japan, is that Italy can not print its way out of a default. It must rely on the ECB for monetary policy.

Now that Mario Draghi, an Italian, is at the head of the ECB, we could see more bond purchases of Italian debt by the ECB. That does not mean that Draghi is likely to stray too far from his predecessor, Jean-Claude Trichet. Draghi, like Trichet before him, is a bit of a hawk, and will not just go into quantitative easing mode right away. Italy would have to seriously stumble for an extended period of time for that to happen.

If French President Nicolas Sarkozy and others are able to convince China, and to a lesser extent, Japan, to invest in the EFSF during their trip there, it could help ease fears. Yet, these two Asian nations may make Sarkozy an offer he can not refuse.

Otherwise, Italy and perhaps this plan to save Europe may sleep with the fishes. It might be time to sing Arrivederci, Roma.

ACTION ITEMS:

Bullish:
Traders who believe that Italy will be saved and borrowing costs will come down might want to consider the following trades:

  • Going long the Italian ETF (NYSE: EWI) may make sense if the EFSF really is a "bazooka."

Bearish:
If you think Italy is too big to really be saved you may want to consider alternate positions:

  • Short Italian banks at will. All of them which plunge sharply if Italy can not be saved.

Neither Benzinga nor its staff recommend that you buy, sell, or hold any security. We do not offer investment advice, personalized or otherwise. Benzinga recommends that you conduct your own due diligence and consult a certified financial professional for personalized advice about your financial situation.

Posted-In: EFSF European Union italy Jean Claude-TrichetLong Ideas Bonds Markets Trading Ideas Best of Benzinga

 

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