Italian government bond yields fell sharply on Friday after Rome passed new austerity plans, clearing the way for a new government but pressure may increase again ahead of a bond auction next week. Italy's Senate approved economic reforms intended to reverse a collapse of market confidence, kicking off a rapid transition that will end the Berlusconi era and clear the way for an emergency government within days.
Europe's third-largest economy has overtaken Greece as the focus of the eurozone debt crisis this week, with yields on Italian benchmark 10-year bonds having risen as high as 7.5 percent, well into levels considered unsustainable. Analysts fear Italy's potential inability to fund itself could be a systemic risk given the size of its economy and its status as the world's third-largest government debtor.
"It's a systemic not a fundamental crisis driven by the weakness at the heart of the eurozone which is 17 fiscal policies and one monetary policy and the crisis continues until that is addressed," said Richard McGuire, rate strategist at Rabobank. "Political changes and reforms are necessary but not sufficient." The next market test comes on Monday when Italy plans to sell 3 billion euros of five-year government bonds. Ten-year yields fell almost 40 basis points to 6.57 percent and two-year yields were down almost 80 bps.
"It's hardly a favourable state of affairs if that's where we're at even with the support of the central bank," McGuire added. Traders said they had not seen any ECB buying on Friday and that liquidity was thin with some of Europe closed and the US bond market shut for Veterans Day. One trader said the sell-off this week in Italian bonds had been fuelled by real money sellers who have to liquidate their positions beyond certain levels.
"By and large what we have seen here has been ... forced sellers, technical sellers as yields have pushed through the 7 percent handle, and the only person who stepped in has been either the ECB directly through the SMP (security markets programme) or the local central banks which are also part of the ECB programme," the trader said.
Despite the momentary relief and the tentative progress made in Italy and Greece, the underlying backdrop remained supportive for perceived safe-haven debt. Greeks lauded the nomination of new prime minister Lucas Papademos on Friday and expressed hope his government could put the economy back on track and calm political turmoil that has threatened to force Athens out of the eurozone.
German Bund futures settled 129 ticks lower at 137.26 and 10-year German government bond yields rose 11 basis points to 1.87 percent. However, the sell-off was seen as little more than a dip, with the path of least resistance still towards lower yields while there was no definitive solution to the crisis.
While it remains to be seen if a new Italian government can do enough on austerity to restore market confidence, there is pressure on the ECB to keep buying bonds in the secondary market, even though it has said its purchases are a temporary measure. "After the moves we have seen this week, and the yield widening ... it takes a brave investor to go in and buy Italian debt at these levels without there being a more permanent or agreed rescue mechanism in place," Elisabeth Afseth, fixed income analyst at Evolution Securities said.