Recent research from Goldman Sachs says the breaking point for Italian yields is 7% or just 1.3% higher than current levels. As the EMU fails to create a sustainable solution the markets are wielding an enormous amount of power over the entire global economy. Another substantial economic shock is closer than most likely believe. FT Alphaville provides a nice summary of the situation in Italy:
“3. At what level would Italian yields become unsustainable?
Yields at somewhere around 7% are likely to become problematic, but this depends critically on our assumptions.
If the current rise in bond spreads is sustained and subsequent debt is issued at higher yields, the Italian government’s debt servicing cost will increase. While it would take a number of years for costs to rise (as debt is rolled-over), current yield increases would add to investor concerns that levels of public debt in Italy may not be sustainable. Theoretically, there is a threshold level for bond yields at which such worries over debt sustainability become self-fulfilling …
4. What is the likely impact of rising yields on financial conditions and GDP growth in Italy?
Higher interest rates and a falling stock market have tightened financial conditions by around 40bp in the past two weeks, adding downside risk to the Italian growth outlook.
We gauge the tightness of financial conditions in Italy by tracking four variables (the Italian 3-month interbank interest rate, the 10-year government bond yield, the trade-weighted currency and an aggregate stock market index) and assigning each a weight based on its relative importance in explaining future year-on-year GDP growth.
On this metric, financial conditions in Italy have tightened sharply in recent months—by around 130bp from their average in Q1 to their current level in mid-July. A substantial part (around 40bp) of this move has occurred in the past two weeks, as Italian short-term interbank rates have risen, long-term bond yields have hit post-Euro-zone highs, and the Italian stock market has fallen by some 7%. The Euro has depreciated—providing an offset to the tightening in conditions—but given Italy’s high degree of intra-Euro-zone trade, the weight of the currency in our measure is relatively low. In comparison, given the limited outflow of capital from the Euro-zone as a whole, yields have eased for less risky Euro-zone assets and our Euro-FCI is down about 30bp since the end of June.
On past correlations, if higher spreads are sustained and the stock market fails to recover, the negative impact of this sharp tightening in financial conditions on Italian GDP growth could be significant. There is a risk that annual GDP growth could fall from +1.0%yoy in Q1 into negative territory …”
Source: FT Alphaville
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.