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Credit Insights

Something at Work in Italian Bond Market

Last week's jump in Italian bond prices did not appear emblematic of a typical market action.

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Our skepticism of two weeks ago ("That Can't Be Right") that the latest bailout framework was the solution to stabilize the sovereign debt markets was prescient. Italian bonds cratered in the middle of last week; the 10-year bond fell to new lows Wednesday and the yield blew through 7%. The bonds did quickly reverse those losses before Italy's auction of 12-month bills Thursday. On the short end, 1-year Italian bonds quickly tightened 75 basis points in the few hours leading up to the auction. In fact, bonds quickly rose across the entire yield curve before the auction.

Based on my experience, the jump in bond prices did not appear emblematic of a typical market action. I suspect the European Central Bank was in the market to make sure the bill auction cleared at a yield well inside 7%. After the bill auction, Italian bond prices continued to recover most of their losses from earlier in the week and ended the week nearly unchanged. The 10-year Italian bonds ended Friday at 6.88%, a 510-basis-point spread over German bonds. The market has drawn a line in the sand at 7% for Italian interest rates. Inside 7%, the market believes there is still hope that Italy has enough time to strengthen its economy, get its finances in order, and remain solvent. Over 7%, the market judges that the increase in interest expense would be too great for the country to ever get back to sensible debt metrics, putting Italy on a debt spiral toward insolvency.

David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.