Unconventional Wisdom -- Made in Germany::Macquarie Research

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Unconventional Wisdom
Made in Germany
Event
 The sovereign debt crisis in Europe has worsened with Italian bond yields
rising at an alarming rate.
Impact
 The assault on the Italian bond market has been a surprise. While
government debt levels are very high, this has been the case for many years
and Italy does not have the acute budget deficits of countries such as Greece.
 So there is uncertainty about why financial markets should have turned on
Italy. But while there are a range of possible explanations, one contributing
factor has been monetary policy in the Euro Area.
 One of the big differences this year compared to the upheavals of 2010 is
tighter monetary policy in the Euro Area. Catering to the needs of the German
economy has put additional pressure on peripheral Europe. If Germany
remains insistent on tough austerity measures, can the ECB still conduct
policy according to the needs of the German economy? This will be a huge
issue over coming months.
Analysis
 The massive increase in yields on Italian bonds in such a short period of time
must be triggering alarm bells for European policymakers. The Italian 10-year
yield started July around 4.75% and then surged to a peak around 6% in just
a few weeks. It is one thing for yields to jump in small markets. But in a big
bond market like Italy’s, such an increase is alarming.
 Especially when benchmark bond yields are falling elsewhere. As Italian
yields have jumped over recent weeks, the US and German 10-year yields
have fallen by 30bp. As a result, the spreads of Italian rates over German
rates have widened substantially.
 Although Italy was viewed as potentially at risk as the sovereign debt crisis
intensified, there was a widespread belief that the differences between Italy
and countries such as Greece would limit the damage. The primary budget
balance (which excluded interest payments) is in much better shape in Italy, a
large proportion of Italian government debt is held locally and the high
accumulated debt level has been known for years. Yet it seems that these
differences have been insufficient to prevent a rout.
 So why should Italy suddenly be a focus of market attention? A wide range of
causes have been suggested including a dispute between the prime minister
and the finance minister and ratings downgrades of some Italian banks. But
there is still enormous uncertainty about the real reason for the market assault
on Italian bonds.
 There is, however, one very unhelpful development that probably played a
part – monetary policy in the Euro Area.