Sequel to Fellini's 8 1/2: The Italian Bond Market

"8 1/2" was a great movie, but having bond yields approach that number is downright scary. Last night, the London Clearing House disrupted markets even further than they already are by raising margins on Italian debt, sending yields on Italian, and French debt soaring. The yield on Italian ten year debt is up over 7%. Some have said that 6% is the point of no return, so 7% is extremely troublesome. In other words, Italy is next to go, as the bond vigilantes demand that something be done about the country's fiscal state now. Like yesterday. Pronto. By increasing the amount of collateral to be posted as initial margins on trades, this has caused a massive dumping of Italian debt. It has also caused tomorrow's Italian bond auction to be cancelled. This is going to affect each and every European bank, as Italy has the third largest debt market in the world. Things have gotten so bad, Prime Minister Silvio Berlusconi has offered to resign once the 2012 budget is passed (who knows when that will be), and the yield on Italian ten year debt is over 7%, around 7.2% as of the time of this article. With yields on Italian debt beyond the level of repair, this effectively kills the European Financial Stability Facility (EFSF), since the fund can not help Italy at this point. It only had $250 billion or so in the fund, and there is no hope of levering up the fund to $1 trillion, as the EU Summit had said. Effectively, the only thing that can save the European Union as it currently stands is a Eurobond, but German Chancellor Angela Merkel has been vehemently opposed to that. It looks like she may no longer have a choice, if she wants to keep the Euro intact. The costs to Germany would be extreme, but it is either a Eurobond, or the end of the European Union as we know it. Things have gotten so bad over there that there were rumors of an emergency ECB meeting this morning, and the ECB had no comment on it. With the banning of sovereign credit default swaps (CDS), this has amplified the problem. Instead of people selling the hedges, they now have to sell the actual instrument, and it has caused Italian debt to soar in the past few weeks. It took Greece months and months to see these levels. It took Italy a matter of days. It has caused Dr. Doom, Nouriel Roubini, to come out and make some extremely negative comments about the fate of Italy, and unless something is done by the ECB or even the Federal Reserve, then the fate of Italy is all but sealed. Italy needs to put in place austerity measures and pro-growth measures at the same time, something that really has not been done effectively in any part of the globe. Tightening the belt and trying to grow at the same time is an oxymoron, and this time it's a $3 trillion oxymoron. There could be additional margin hikes on Italian debt, something Goldman Sachs expects to happen should the spread of Italian debt over comparable German bonds continue to stay this wide for this long. If it does, the ECB may have no choice but to print Euros. The IMF does not seem to want to get involved, and China is flaky about this, at best. Otherwise, say goodbye to Roma. ACTION ITEMS:

Bullish:
Traders who believe that Italy will not default and will ultimately be bailed out by either the EU or China might want to consider the following trades:

• Going long the Italian ETF EWI at the height of the crisis in the media may make sense as it will not be long before Italy is bailed out once the news hits the precipice.

• Also consider Italian banks, such as UniCredit, Intesa, and Banco Popolare, as these Italian banks are likely to see massive short coverings if there is a deal.

Bearish:
If you agree that Italy is just too big to be bailed out you may want to consider alternate positions:

• Short Italian banks at will. Also consider shorting the CurrencyShares Euro Trust ETF FXE, and Morgan Stanley MS, which has an extremely large position of Italian debt.
  
  

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