When bond prices fall,yields increase,offering investors a higher reward for the risk they take on. Italy's soaring yields are an indicator that investors now see higher risks associated with buying the country's debt.
Flight to safety
On the other side of the Atlantic in the US,yields on 10-year Treasuries posted their biggest single-day fall since the Brexit vote in 2016. Having yielded more than 3 per cent earlier this month,they fell 15 basis points to 2.78 per cent overnight. The yield on two-year Treasuries was down 17 basis points to 2.32 per cent.
The US yield curve,with the difference between two-year and ten-year treasury bonds now only 42 basis points,is as flat as it has been since the global financial crisis,which points to expectations of a weaker outlook for US economic growth.
European and US stocks also fell sharply,with banks hit hard,and the euro wasn't spared either. Meanwhile,the US dollar – and the Japanese yen and Swiss franc -- all strengthened overnight in what was an obvious flight to safe havens. The markets were in"risk-off"’ mode.
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Stand-off in Italy
The crisis in Italy came after the alliance that formed government after the March elections nominated Giuseppe Conte,a law professor with no political experience,as prime minister. Economist Paolo Savona,an extreme eurosceptic,was proposed as economic minister.
President Mattarella rejected the nominations. Provocatively,he appointed a former IMF official,Carlo Cottarelli,as interim prime minister with responsibility for forming a"technocratic"government.
Southern Europeans resent the IMF for -- along with the ECB and European Commission -- imposing harsh"austerity"measures and tough debt and deficit rules on distressed economies post-crisis.
Given the likely lack of support from the alliance,it appears almost inevitable that Italy will have a fresh election in September,with the very real prospect it will effectively end up as a referendum on Italy’s continued membership of the eurozone.
Bitter aftertaste
Despite a general recovery in EU economies – they grew at 2.5 per cent last year,their strongest growth for a decade – the economic underpinnings of the eurozone,particularly in southern Europe,remain weak and vulnerable.
Compared to the economies in the North,southern European economies have lagged in the sluggish post-crisis recovery and their debt-to-GDP levels are higher than they were in 2008. Italy’s is above 130 per cent.
Where Mario Draghi was able to calm markets in 2012 with words,and then a big dose of central bank liquidity,the issues that have made Italy a threat to the EU and euro aren’t so much financial,as they were then,as political.
But a Quitaly would still create financial chaos,with other weaker EU members almost certainly following Italy out of the eurozone.
Common markets and rules and regulations would be torn up,new currencies and their value would have to be established,financial markets would implode,the European banking system destabilised to the point of collapse,sovereign debt investors would be exposed to huge losses as the denomination of their investments was switched from the German and French-anchored euro to lira,pesos and drachmas.
There would be tidal waves of capital – and waves of losses -- fleeing Europe as investors and financial institutions scrambled to the exits.
Another GFC?
There would be another global financial crisis,with less capacity for central banks and governments to respond to it than there was in 2008.
Yet it is in fact the very prospect of something worse than the last global financial crisis that may prevent all of this from occurring.
The moderates in Italy,and the institutions and key political figures within the EU,will try to counter the eurosceptics by arguing that life outside the eurozone would be even worse than life within it.
They’d probably be right.