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FOREIGN EXCHANGE

Italian and French bond spreads hit record euro-era highs

Italian bond yields surged to 6.4% on Thursday, a euro-area high and at levels many believe put Italy on an unsustainable debt-repayment path.

 

Worries over a proposed Greek referendum on the most recent bailout agreements and an imminent collapse of Greek prime minister George Papandreou’s government have heightened fears of a disorderly Greek default, but the key issue that will determine the euro’s fate is Italy and how much support the ECB will be willing to lend to restore at least temporary confidence to bond investors. The spread on Italian bonds over German bunds rose 459 basis points, as Silvio Berlusconi’s Italian cabinet meeting on Wednesday night failed to push through immediate economic and debt-reduction reforms, and Greece’s political crisis raged on.

Further signs of a sharp fall in market sentiment were seen as France’s borrowing costs rose, sending spreads over German bunds to new euro-area highs of 135bp, as investors feared France my lose its AAA rating, putting into question the future strength of the European Financial Stability Facility fund.

Indeed, the delay of the EFSF own bond issue on Wednesday also hurt sentiment, as investors spurned the €3 billion 10-year debt offering from the eurozone’s rescue fund.

Analysts say any sustainable euro rally will only come when the EU has secured external investment to leverage the EFSF but the recent deterioration in confidence surrounding the Greek political situation is threatening positive developments to this end.

“Greece is still threatening to be the straw that broke the camel’s back,” said Kathleen Brooks, FX strategist at Forex.com. “The EU needs to desperately shore up the EFSF to try to protect Italy, yet the Chinese won’t invest until the Greek political crisis is stabilised.”

Meanwhile, Mario Draghi’s first week as European Central Bank president comes at a critical time for the eurozone. The ECB shocked markets with a 25 basis point rate cut  with the incoming president’s post-meeting press conference heavily scrutinized. The bank's shift to a more dovish stance was eagerly awaited at a time when euro-area growth has slowed close to recessionary levels.

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