Key Take Away from This Week

The key take away from this week is not the weakest US jobs data in nine months. After all, it was well appreciated that for a number of reasons the US economy has lost some momentum in H1. Even the Federal Reserve has acknowledged this. Nor is the take away from the week that European officials have yet to design a way to get the private sector to participate in aiding Greece without taking the risk that the rating agencies would recognize the scheme as a distressed exchange and give Greek bonds a default rating. With the next tranche of aid to be handed over, there is plenty of time--a couple months at least, for Europe to figure a way to square the circle.

Instead, the significant development this week is the pressure on Italy. Italian bonds sold off every day this past week and this brought the 10-year benchmark yield to its highest level in 9 years. The 40 bp increase is the most in a week since last January, as the Greece situation was what British English calls "hotting up". The premium Italy must pay over Germany has widened to almost 250 bp, the highest under EMU. Italy remains committed to a balanced budget in 2014. In an effort to achieve this the Italian government has unveiled a 40 bln euro savings program. A Moody's analyst spoke for many when he questioned whether the political situation will allow for the effective implementation.

A combination of domestic political woes for Prime Minister Berlusconi and Finance Minister Tremonti, the slashing of Portugal's credit rating by Moody's, when both Moody's and S&P has Italy on negative credit watch, and nervousness ahead of next week's release of European stress tests conspired to undermine Italy. There is also some concern that Italian banks, which are among the largest holders of Italian sovereign bonds, have a waning appetite to expand sovereign exposure, given the huge redemptions over the next 18 months.

The Bank of Italy Governor and the next ECB President Draghi seemed to counter market rumors that some Italian banks might fail this year's stress test. Italian banks slid today and a trading in a couple of large banks was suspended after they hit the exchange circuit breakers. The Italian stock market fell 3.3% today, while financials were off 5.2%, with banks off 5.7%. The largest bank fell almost 8%. Since the end of April, EWI, the MSCI I-share ETF has fallen nearly 19.5%, which is approaching bear market territory. The FTSE Italia All-Share Index has fared slightly better, falling about 15% in the same period. It is with this backdrop that Italy will sell bills on July 12 and bonds on July 14.

The bank stress tests on due July 15, but both Draghi and "banking sources" told the press that Italy's banks (five of which were subject to the stress test) have all passed the test. Even if true, the increasingly fragile state of the sovereign undermines the banks. Rising sovereign yields force up the bank bond yields as well. The five year CDS for Italy has risen by nearly a third this week and at around 240 bp is still about 25% lower than Spain. The risk is that this gap and the interest rate gap narrows in the coming period.

On top of this, evidence is mounting that the Italian economy stagnated or worse in Q2. Earlier this week, Italy reported that both its manufacturing and service sector PMI fell below the 50 boom/bust level. Earlier today, Italy reported that industrial production fell 0.6% in May. The market had expected only a 0.1% decline. Poor growth or a renewed contraction will only exacerbate the pressure on its financial markets and its ratings. If the Italian situation does not stabilize shortly, it can make the Greek, Irish and Portuguese problems seem like a cake walk.