Rome Burns

There is one overarching story today and it is Italy.  Berlusconi's resignation reveals political fragility of the euro zone''s third largest economy.  Lost on many observers is the fact that the Berlusconi phenomenon is just a much an effect as cause of the political paralysis.  As Italian yields move into panic zone, with the 10-year yield shoot well through 7%, the euro has comes off sharply.  It is poised to test the $1.3570-$1.3600 bank of support after having briefly risen through yesterday's highs in early Asia. 

LCH Clearnet raised the margin on Italian bonds by 3.5%-5% across all maturities.  The margin on 7-10 year Italian government bonds was hiked to 11.65% from 6.65%.  It seems to aggravate the selling pressure in what could be the beginnings of a vicious cycle. 

The piercing of the 7% yield level is important psychologically and this needs to be addressed.  However, the real cost to Italy is not so great immediately, if the genie can be put back into the bottle, so to speak.  Italy's average maturity is near 7 years and is among the longest in the euro zone.  Assuming around 6% yield on all its debt (~1.9 bln euros) Italy would pay about 114 bln euros in debt servicing costs.  At 7% the debt servicing bill rises to 133 bln euros.  Projected tax revenues are three to four times larger than this.  

Moreover, this exercise may be misleading because the higher yields would really only apply to new issuance and given the stock of debt, the new debt sold only slowly changes the average yield.  Next year Italy has an estimated 300 bln euros of maturing debt next year. 

Meanwhile, back in Athens, it has been three days and still no agreement on a new unity government.  surely it makes one question the the strength of that unity.  Although a resolution is expected shortly, the Papandreou-Berlusconi issues raise larger questions over the political stability in the periphery and whether the cost of addressing fiscal problems is the creation of a political crisis. 

A secondary development today, overshadowed by European developments is the slew of Chinese economic data.  The most important of these is the CPI which fell to 5.5% in Oct, a five month low, from 6.1% in Sept, owing in large measure to the fall in pork and other food prices.  The Ministry of Commerce's pork price index was up 42% year-over-year in Oct, down from 50% in Sept. The wholesale food index was 11.3% higher year-over-year in Oct, down from 16% in Sept.  Food is about one third of the CPI basket.  This will help set the stage for modest easing in monetary conditions in China.  Other data included industrial production, fixed investment and retail sales.  These reports point to a gradually slowing economy and one in which a soft-landing still seems the most likely scenario. 

The UK reported a wider than expected trade deficit.  The global deficit of GBP9.8 bln  was almost 20% worse than the consensus.  This risks a downward revision to Q3 GDP.  Earlier this week, we identified the potential for a low risk selling opportunity for sterling as it approached its 200-day moving average. 

Yesterday sterling peaked near $1.6130, about 15 ticks shy of the 200-day average.  A break now of the $1.5950 area could see another cent decline in short order.  Sterling is faring better than the euro and the cross is flirting with support in the GBP0.8500-30 area, having recorded its lowest level since  the end of Q1.    A break here could see another 1-2% decline. 

The heightened risk environment in general has seen the yen and Swiss franc come back bid.  The market is somewhat less nervous about either central bank intervening.  Given the track record, many players think they can hold on if the BOJ intervenes and window of opportunity for the SNB to lower the Swiss franc's cap appears to have closed for the time being.