Yields on Italian government debt reach danger levels, threatening the euro zone.
Forget about company fundamentals. Ignore the UK's economic statistics. The only thing driving stock markets this year is politics and, to be specific, euro-zone politics.
The PIIGS problem
So far in 2011, it's all been about the PIIGS of Europe: Portugal, Ireland, Italy, Greece and Spain.
In a series of sharp zigzags, share prices have swung wildly as hope and fear have alternately gripped investors. Indeed, as I pointed out earlier this month, the FTSE 100 index of elite British companies has been unusually volatile this year.
Late last week, stock markets headed south because of 'Papandamonium' caused by the decision of Greek Prime Minister George Papandreou to hold a referendum on his country's latest bailout. Within days, Papandreou made an abrupt about-turn and is expected to step down shortly as leader.
This week, share prices were lifted by a 'Berlusconi bounce' from Italian Prime Minister Silvio Berlusconi's promise to resign after seeing through Italy's latest austerity package. As a result, the Footsie rose a little over 1% yesterday.
Mr Bond strikes back
Although political leaders do keep an eye on their national stock markets, the real power behind financial markets is wielded by so-called 'bond vigilantes', who manage tens of trillions of dollars in bonds.
When these investors in government and corporate IOUs lose their cool, all hell can break loose. Hence, James Carville, political advisor to former US President Bill Clinton, once dryly remarked:
"I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody."
This morning, bond investors made their feelings about Italy very clear, as they sold Italian government bonds by the lorry load. As a result, Italian bond prices plunged, driving up yields on these fixed-income investments to record highs.
The Italian sell-off
As I write, the yield on the 10-year Italian bond has leapt to nearly 7.36%, up nearly 0.6 percentage points in less than 24 hours. Earlier today, this yield peaked at more than 7.48%, which is a record high since the euro zone was established in 1999. In comparison, ten-year German Bunds yield a tiny 1.73%.
Furthermore, Italy's one-year bond yield is also showing signs of severe stress. It currently stands at 8.15%, which is almost eight percentage points above the 0.24% yield offered by one-year German Bunds.
Frankly, at these levels, bond investors are pricing in a 'haircut', which strongly suggests that Italy will have to seek some kind of bailout from the European Union and the International Monetary Fund. Indeed, when bond yields for fellow PIIGS Portugal, Ireland and Greece surpassed 6.5%, these countries admitted defeat and passed around the begging bowl.
Then again, at €1.9 trillion, Italy's bond market is vastly bigger than any other in Europe. What's more, Italy has to roll over at least €360 billion of this debt next year, which it simply cannot do at current yields.
Hence, it looks like the game is up for Italy and it will have to 'do a Greece'.
Otherwise, bond investors will panic, selling weaker bonds and fleeing to the relative safety of safer securities such as US Treasuries, German Bunds and UK Gilts. When bond investors seek safety, government with weak finances and outsized debts -- such as Italy -- take a beating.
What next?
Tom Paterson, chief economist at gold broker Gold Made Simple, warns:
"The sovereign-debt crisis continues unabated and, in short order, has claimed two more prime ministerial scalps... Italy’s borrowing costs have risen to unsustainable levels and the country now runs a serious risk of being swamped by its debts. At these levels of risk, no-one is going to want to take on Italian debt... 1,600 years from the first Sack of Rome, some Italians are seeing Barbarians at the gate once again."
"It's sobering to remember that just one year ago, Italy's borrowing costs were perceived as low. Some commentators even suggested that this proved Italy was fine and should borrow even more. Now those same commentators are saying the same about the UK and its borrowing costs. But Italy’s current pain highlights just how quickly things change -- the UK has been warned."
After Italy, which will be the next domino to fall? Will it be Spain, as many are betting on, or will the UK fall foul of bond investors? Let's hope David Cameron and George Osborne can keep Mr Market's confidence until growth takes off again!
More from Cliff D'Arcy:
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