Italian unrest shakes markets

illustration: DNB markets dealingroom in oslo

(12.07.2011) Investors' worries concerning the fiscal situation in the euro zone has spread to Italy, the currency union's third largest economy. Global stock markets and long-term government bond yields have fallen.

By Kjersti Haugland, Senior Economist at DNB Markets

The euro is weakening, while the dollar and the Swiss Franc are gaining on their status as safe haven. Inflation far below expectations also contributed to falling FRA rates and a weaker NOK yesterday.

The week started off with high and increasing volatility, and the markets are currently strongly occupied by worries concerning debt-burdened euro members. The finance ministers of the euro zone met for another meeting about the Greek situation yesterday, which resulted in a statement that loans will become cheaper, maturities longer and the emergency fund mechanism more flexible in order to ease the situation for distressed countries. No deadline was set for formal measures to be passed however. While the ministers were gathered, the unrest was shaking markets, sending global stock markets, as well as long government bond yields, down and the euro weaker. The dollar and the Swiss Franc gained on their status as safe havens.
Investors have turned their attention to Italy, which has the second largest debt burden among the euro countries (gross debt of about 120% of its GDP, only Greece is higher). This is bad news, as Italy is the third largest economy in the EMU. According to Reuters an unofficial source from the ECB has said that if Italy needs rescue, this would require a doubling of the EFSF fund to 1500 bn euros. The spread between Italian and German 10-year government bonds has increased strongly, and the price for insurance against default on Italian government debt has come up to record-high levels (5-year CDS near 300 basis points), although the level remains far below Greek and Portuguese levels (2250 and 1112).
The debt level is high, but many factors points to a more benign situation for Italy. The main part of its debt is domestically financed. The saving in the private sector is high, and the country is significantly less dependent than Greece on external financing. The fiscal discipline has been high during the financial crisis, and the deficits significantly lower than in other PIIGS-countries. Finance minister Giulio Tremonti has been known as a fierce advocate of austerity plans, which explains why part of the trigger behind heightened concern about the Italian situation was rumours that Prime Minister Berlusconi wanted to fire Tremonti.

Another trigger is a drop in Italian bank shares, due to rumours about poor results in the stress tests that are to be published on Friday. In any case: If the market distrust persists, and accelerates, it is no doubt that the Italian financing position will become very challenging. In that case, the euro cooperation will face another severe test.
Norwegian FRA rates have pulled down by up to 16 basis points since yesterday morning, and the NOK has weakened somewhat. This must be seen in connection with the unrest abroad, but some of it may also be explained by yesterday's news that inflation was significantly lower than expected in June. The annual growth in CPI ATE (CPI excluding energy goods and adjusted for taxes) came to 0.7%, down from 1.0% in May, and well below consensus (1.0%) and Norges Bank's estimate (1.1%). The price growth was weaker than expected on a broad front.

One number is hardly enough to change Norges Bank's hiking plan, and August inflation is released on the same day as the next interest rate meeting. Hence, a hike in August (as indicated by Norges Bank's interest rate path), is very likely to be executed. For the rest of 2011 the path indicates a rise in October or December, or at both meetings. We continue to believe that the central bank will choose to hike at both meetings, but if the deviation from their inflation path persists, the probability that the central bank skips one of them increases.
The euro zone finance ministers meet again this afternoon. The most important macro releases today are inflation in Sweden and the UK, and the minutes from the FOMC-meeting in June.