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Italy's bond yields

With the third-largest government bond market in Europe and 167 billion euros in debt due to mature in 2012, Italy is considered “too big to fail”.

The resignation of Italy's Prime Minister Silvio Berlusconi initially failed to calm the concerns about Italy's creditworthiness.  Concerns about Italy were exacerbated when a major clearing house, LCH Clearnet, asked for larger margin deposit to trade Italian bonds - to cover the increased risk of non-payment, as a consequence the bond rate jumped above 7%.

The European Central Bank (ECB) must be bold

In recent days, the market action has been typical of the lead up to previous bailouts.  Time is now at a premium.  Unhelpfully, several banks have announced they have reduced their holdings of Italian debt to calm market concerns about their own well-being. This puts pressure on all Italian creditors to sell, encouraging the market pressures to become self-fuelling.

Most experts believe only the European Central Bank has the capacity to resolve this issue. But, it has no political mandate to act as lender of last resort. The problem is that the Eurozone treaty doesn't support it: Article 101 prohibits the ECB from lending to governments and Article 103 says the Eurozone should not be liable for member-state debt.  Acting as lender of last resort to sovereigns entails a great deal of moral hazard. It is different from being a lender of last resort to banks - at least they post decent collateral. Even if Italy's borrowing costs are brought under control, the economic growth outlook remains weak: the IMF has forecast 0.6% GDP growth for Italy in 2011 - but annual GDP growth would have to match borrowing costs to prevent Italy's massive 120% debt-to-GDP ratio from growing.

Political wrangles

In order to sustainably boost economic growth, Italy needs to restore its external competitiveness, which is a promise that Berlusconi has failed to deliver on over the past decade.  Berlusconi's resignation has to be followed by the formation of a new government that can push through the necessary structural reforms that Italy needs. The market's preferred solution would be a coalition technocratic government that would be able to provide more credibility to the approval of tough but necessary fiscal measures and reforms.

The Italian Senate overwhelmingly passed Mr Berlusconi's package of spending cuts and tax increases on Friday.  Passage through the lower house was seen as a formality and Berlusconi drove to the President to tender his resignation Saturday.

US stocks last week were boosted by the better than expected Michigan Confidence data, a survey of businesses in key market sectors.  Greece's new PM Mr Lucas Papademos, another economist/technocrat leading an interim Government was sworn in to oversee the implementation of the €130bn bailout.  Stock markets rallied strongly Friday on these developments and the euro is surging early Monday.

Europe's sovereign debt issues will continue to be a key for markets in the week ahead.  Lots can go wrong in the implementation of these packages but for now, some relief.  We continue to be confident that the Eurozone and ECB will provide the necessary support and programs necessary to work through the debt issues and bring stability back to the region.

Our broad view of the current economic environment remains unchanged. We believe that volatility will continue for some time given the events engulfing both developed and developing economies. Though we are confident the Eurozone debt crisis and impact any contagion it may have on countries and financial institutions will be resolved, if the European Central Bank is unable to address and implement strong policy and financial assistance, the possibility arises that investor confidence may fall further.

"Probable impossibilities are to be preferred to improbable possibilities."
-- Aristotle (384 BC - 322 BC)