Euro stabilises after Italian auction but risks remain acute
The euro bounced back from lows of $1.3485 against the dollar, ending the London morning close at $1.3600, as Italy was able to sell €5 billion of one-year Treasury bills in Thursday’s crucial bond auction.
Reports of heavy European Central Bank buying of Italian bonds brought yields back below the critical 7% mark, but the average yield on Thursday’s 12-month T-bills was still high at 6.087%, well above the 3.57% received in the last one-year auction and is the highest level in 14 years. Shortly before the ECB’s activity in the secondary markets, the spread on 10-year French bonds also started to accelerate, widening to 165 basis points over German bunds during the early London session. This sent an alarming signal that, without a swift reversal of sentiment, contagion is at risk of spreading to the eurozone’s second largest economy.
Perhaps of greater importance will be Monday’s auction of five-year Italian paper from which the government reportedly aims to raise €3 billion.
“Looking ahead, the euro’s performance is likely to be highly dependent on the success of these auctions,” says Hans Redeker, head of global FX strategy at Morgan Stanley.
“If international and private investors continue to stand aside, it is difficult to see these auctions turning out successful, thus keeping the euro under selling pressure.”
Wednesday’s spike in Italian spreads above the critical 450bp level saw EURUSD fall to one month lows of 1.3483 and global markets fell sharply, with the S&P losing 3.67% and the FTSE, DAX and CAC losing 3.78%, 2.21% and 2.17% respectively.
The eurozone remains in a highly fragile situation and a sustained stabilisation will require rapid action from Italy to instil credibility in its government, with the top priority being to implement crucial structural reforms. Italy will vote on the austerity package by Monday at the latest, with a vote over the weekend now possible to open the way for the much-awaited resignation of Silvio Berlusconi.
However, with short-term fiscal options running out, analysts are calling for aggressive action by the ECB to restore confidence in the eurozone.
The ECB has, so far, maintained its stance against large-scale buying of government debt, as this would essentially constitute the monetisation of eurozone government debt and lower incentives for fiscal reform in profligate nations.
Indeed, large-scale commitment to buy unlimited quantities of distressed bonds would require a controversial change to the central bank’s remit, and without a substantial leveraging of the EFSF in the near future, the ECB might be the only candidate to lower the prospect of default in the eurozone and prevent the spread of contagion.
“Days like yesterday [Wednesday] bring forward the point where Europe will have to decide what it ultimately wants,” says Jim Reid, macro strategist at Deutsche Bank.
“Our long-held belief remains that the ECB might eventually have to have a balance sheet of trillions of euro to avoid euro sovereign haircuts/defaults and even to keep the euro from breaking up in the years to come.”