A Greek tragedy that may be the fall of Rome

Greece has had more attention than is warranted from such a small contributor to European GDP, but with the recent announcement of a bail-out referendum at the forefront of investors’ minds, it is not surprising that Greece is deemed responsible for renewed market volatility this week. However, in my opinion, the real focus must be on Italy and its substantial debt burden.

Whilst equity markets experience volatile mood swings, it is the debt capital markets that provide a more clinical overview of each country’s health. The market measure of confidence in the ability of the EU leaders to act in time might be derived from the yield on the Italian 10 year treasury bond (BTP) as Italy is the largest of the southern European debtor nations, with a debt to GDP ratio of 121%. The 10 year BTP has been climbing towards the 6.0% yield level through the last quarter and despite the announcements of last week, the borrowing costs continue to mount.

This week it reached a high of 6.33% which is widely believed to be unsustainably high.  We then saw an abrupt yield drop late on Tuesday, causing us to conclude that the ECB has stepped in again and purchased a raft of Italian debt.  With the bonds still deemed as a risky investment, there is not enough demand to push the yield lower to sustainable levels and with this week’s Italy PMI figure plunging to 43.3, this indicates that Italy is in deep recession.

In our view the size of the EU package needs to be larger and is in need of greater international support including substantial commitments from the US and also China (whose largest trading partner is Europe). Unlike these counterparts who have a clear leader, Europe lacks a cohesive approach due to having 17 orchestra members who are finding it hard to play in concert.  This raises the importance of the ECB as a conduit to help solve the crisis.

How will Draghi differ from Trichet?

Mr Draghi has been handed the ECB leadership at a critical point in the EU crisis and in his first few days at the helm he faces a very difficult interest rate meeting.  Europe is in trouble and monetary policy is probably too tight.  If he cuts rates in his first days in the chair (and we think he should) will he be criticised for being dovish and too hastily changing the course of the ECB’s interest rate policy? 

A bold move such as this would risk more instability so he may decide to maintain course today and wait for the next meeting.  Recession indicators are flashing across Europe so be prepared for rate cuts soon.  Will we see more of the coded language favoured by Mr Trichet to guide markets ahead of big decisions or will Mr Draghi be reticent? 

He is known more as a behind-the-scenes fixer than a speech giver like his predecessor.  As an alumni of Goldman Sachs there may be suspicions of leniency towards the banks.  It will also be interesting to see if critics can avoid bringing his nationality into the spotlight as he uses German funds to buy even more Italian bonds...

What does the future hold?

Expect more volatility as headlines drive markets instead of fundamentals.  It’s a week packed with (more) EU and G20 meetings, rate decisions and bond auctions so investors will probably keep to the sidelines until more clarity is given.  Safety in German bunds and cash will continue to be favoured and the euro will be under pressure while the bail-out plans are still being discussed instead of executed.

Lorne Baring is managing director of B Capital, a Swiss regulated, boutique private bank set up in 2008. He has also previously headed up the Europe (Offshore) business at the Swiss banking division of Barclays.