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Market Overview

Spanish, Italian Yields Spike on Eurozone Fears


On Friday, Spanish and Italian bonds sold off over renewed fears concerning the finances of the indebted nations. Spanish 10-year yields touched post-summit highs of 7.1 percent early Monday morning before recouping some losses. On Monday, the benchmark 10-year traded near 7.053 percent.

Fears over the nature and implementation of the bailout may have sent yields higher. Investors may be worried that the Spanish bank bailout, paid out of the (yet to exist) European Stability Mechanism (ESM), will not come soon enough to prevent a collapse of the Spanish banking system. The ESM is the permanent bailout mechanism and will run in tandem with the European Financial Stability Fund (EFSF) until the EFSF is unwound.

As Deutsche Bank noted over the weekend, the ESM should not actually be active until August 20. Three nations have yet to ratify the ESM: Germany, Italy, and Estonia. For reference, Italy and Germany are responsible for approximately 45 percent of ESM funding. DB notes that they expect the remaining three countries to ratify the ESM treaty changes by the beginning of August. Since it takes 15 days for nations to pay in capital post-ratification, the approximate start date is estimated to be August 20.

The delayed nature of this bailout is of massive importance to markets. Until Spanish banks actually receive the money, they remain exposed to adverse market conditions, as Spanish banks held about 30 percent of outstanding Spanish government bonds in May. Thus, if the sovereign debt market continues to punish Spain, it could hurt asset values at banks and force them to take losses on rapidly diminishing amounts of capital.

Spanish banks were pressured into buying sovereign bonds through the cheap financing of the LTROs earlier this year. These positions could end up making any needed bailouts larger than previously estimated if losses are taken on the bonds.

Italian yields rose in tandem with Spanish yields Monday on similar fears. Traders may sense that if Spain were to default, then Italy is the next likely contagion target. Italy's problem is not spiraling deficits so much as it is a problem of too much debt. Italy's debt-to-GDP ratio of 120.9 percent (as of the end of 2011) trumps Spain's debt ratio of 69.3 percent. However, before interest expense, Italy is running a primary surplus and has a deficit less than the required 3 percent under European treaties. Conversely, on Monday, Spain said that it would miss its deficit targets.

Italian 10-year yields rose on these fears to 6.03 percent after climbing as high as 6.18 percent during European trading. However, traders tend to watch the two-year yield to indicate the ability of nations to borrow short term, for any difficulty borrowing short term (through higher yields) increases interest expense and has a relatively short duration. Spanish 2-year bond yields crossed the dreaded 5 percent level before retracing losses, closing at 4.95 percent. After the European summit, the same bonds yielded a mere 4 percent. Italian 2-year yields were also higher at 3.432 percent.


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