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3 strikes on government bonds

By Sheyna Steiner ·
Tuesday, February 26, 2013
Posted: 5 pm ET

Did you think the sovereign debt crisis was over? The Euro-area has been relatively quiet for a few months but the crisis came roaring back to the world stage in Italy's elections this week. On Monday as the results were posted, the world was shocked and the stock market worried as a fringe movement gained power amid mostly inconclusive results.

The various political parties in Italy all have different ideas about austerity and how to get out of the sovereign debt crisis that has plagued governments and banks in Europe since 2009.

Financial Times reported on the election results on Tuesday:

Italy's political class was left reeling after the upstart anti-establishment Five Star Movement, founded only three years ago by the comedian-blogger Beppe Grillo, garnered 25.55 per cent of the votes, the largest share for any single party.

But the nation was torn three ways between Mr. Grillo and his band of political novices, Pier Luigi Bersani’s centre-left coalition and Silvio Berlusconi’s centre-right alliance, raising the prospect of a second election within months.

"Remember, Italy was going through this severe austerity program. Misery was significant: Unemployment is up and (gross domestic product) is down. In such  a period, it's challenging for the government to keep its place and (former interim prime minister Mario) Monti was the leader of austerity and technocrat and trying to bring the economy back to health," says Werner Bonadurer, a clinical professor of finance at the W.P. Carey School of Business at Arizona State University.

"It's bitter medicine. To bring Italy back to a healthy financial state -- that takes 10 years rather than two," he says. "In a democracy, there is a tendency for the suffering to vote in the extremes."

Why do US markets care?

Italy is the third-largest economy in Europe, and it also boasts the third-largest bond market in the world, right behind the U.S. and Japan, according to David Nice, associate economist at Mesirow Financial in Chicago. If Italy stumbles, the repercussions would be greater than those of the Greek meltdown from last year.

"The Italian elections don't directly affect the U.S., but right now, there is no majority in the Italian Parliament -- they don't really have an operating government. The issues you see are basically rekindling the sovereign debt issues. Italy has a lot of debt, so if you see a spike in their yields, that might cause some issues like we saw last year in Greece and Spain," Nice says.

According to a note from economic consulting firm High Frequency Economics, the impact of the quagmire could be quite serious, including bank losses if Italian bond yields spike, and credit could contract. As well, the reforms put in place by Monti -- who finished fourth in the election -- could be imperiled.

With the prospect of prolonged political uncertainty and deadlock facing Italy, stock markets wilted. In the U.S., equities dropped off on Monday; the Standard & Poor's 500 index closed down 1.83 percent. Treasury yields were down as well, with the 10-year falling 9 basis points. A basis point is one-hundredth of 1 percentage point.

Italian bond yields spiked in the days leading up to the election and rose again on Monday. On Feb. 1, Bloomberg reports, the 10-year Italian government bond gross yield clocked in at 4.32 percent. At the close yesterday, the yield was 4.49 percent, and as of this writing, it has climbed to 4.9 percent.

Bond yields move in the opposite direction of price -- when yields are going up, price is going down as investors sell -- in this case due to the heightened perception of risk.

With no easy political path to reducing Italy's debt, eurozone woes could continue to drag on the U.S. economy -- which has plenty of political problems of its own. The big-picture view is that investors have to deal with sovereign debt issues from major Western powers, and that could cause some anxiety.

"Being unable to reach a solid political outcome diminishes Italy's chances of dealing with its financial problems in any reasonable time frame. We could be looking at several months of political bantering within Italy on nearly every major issue -- in particular, their debt. Given that Italy’s economy is much bigger than Greece, U.S. investor nerves are likely to become even more frayed," says John Stewart, managing director of Vantage Economics in Washington, D.C.

On Friday, credit rating agency Moody's downgraded Britain from AAA to AA1 -- an unprecedented event. Combined with the sequestration issue being hashed out in Congress and the issues in Italy, "it's basically piling on itself," says Nice. "It's three strikes almost -- without being too negative about it -- but it's all over sovereign debt issues."

Are you concerned about Europe, or are America's problems more pressing right now?

Follow me on Twitter: @SheynaSteiner.

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