Italy

First Credit Agricole, now Italy....Maestro: the EUR take down orchestra is reaching the fortissimo cadenza. Next up: the glissando. "On May 20, 2011, Standard & Poor's Ratings Services revised its outlook on the ratings on the Republic of Italy to negative from stable to reflect its views of the heightened downside risks in the government's debt reduction plan. At the same time, Standard & Poor's affirmed its 'A+' long-term and 'A-1+' short-term sovereign credit ratings on Italy. The transfer and convertibility assessment remains at 'AAA'." The negative ratings outlook on Italy (unsolicited rating A+/Negative/A-1+) reflects Standard & Poor's view of the increased downside risks to the Italian government's debt-reduction plan because of potentially weaker-than-expected economic growth and possible political gridlock that could contribute to fiscal slippage. The diminished growth prospects stem from what we consider to be a lack of political commitment to deregulating the labor market and introducing reforms to boost productivity. We believe measures to reduce the bottlenecks and rigidities in Italy's economy are especially important in light of Italy's limited monetary flexibility, which stems from its membership in the European Monetary Union and its limited fiscal room to maneuver because of Italy's high government debt burden."

And so we see another tipping point in action: while absolutely nothing has changed in the fundamentals of Europe's insolvent peripherals, today, for the first time since early January, we are seeing an absolute bloodbath in the risk gauges of the European periphery. As the PIIGS list below shows, spreads are surging, and while it is no surprise that Greece is now trading north of 1200 bps following a weekend full of Greek default chatter, the important observation is that Spain and Italy are once again in the default mix.

• Portugal 615 (+15) - officially insolvent
• Italy 156 (+13)
• Ireland 588 (+21) - officially insolvent
• Greece 1225bp (+89) - officially insolvent
• Spain 250 (+16)

Remember when we said March would be the cruellest month for Europe? Looks like someone did, at least on a NPV basis, and is now preparing for the next phase of the European Crisis. According to Newedge, there is very large selling on dealer screens in "all kinds of bonds: Spain, Italy, and France." It seems at least one trader is not waiting around to see what the Irish stress test results indicate, and the expectation is that, as Bloomberg noted earlier, bondholder haircuts will be fast and furious.

Today should be fun.

To those who bought Italy CDS last week, congratulations. To those who are buying it right now, also congratulations.

More trouble for Italy, whose CDS has surprisingly not spiked in OTC trading yet. In addition to a "technical glitch" halting its stock exchange, now Reuters reports that the country's natural gas deliveries may be compromised. "Political unrest has hit Libya, which is Italy's biggest oil
supplier and covers about 10 percent of its gas needs. Gas is
carried via underwater pipeline Greenstream, which is controlled
by oil and gas major Eni. "Supplies have not been interrupted, but the situation is
very complicated," Industry Undersecretary Stefano Saglia told a
conference on Tuesday. Gas flows from Libya into Italy through the 510 km pipeline
have been slowing since late Monday, and the situation is
worsening, Italian energy publication Staffetta Quotidiana said,
quoting sources close to the situation. Who would have thought that African revolutionary butterflies can flap their wings and cause the price of that most hated of products - nattie, to be on the verge of surging.

It was less than three years ago that oil went to $140 per barrel and the commodity index climbed over 3 standard deviations and 60% above its 4-year average. An extreme like that should statistically occur about once every century, but despite dropping below the 4-year average for half of 2009, we are now about 2.7 standard deviations and 50% above it, and still climbing. This is a big surprise and a big problem for global prosperity. Now, the turmoil in Egypt has lifted the fear component in the oil price as well. Furthermore, a deep political rift between the US, as Israel's protector, and the newly democratic but primarily fundamental Egypt and its allies in the Islamic world is a distinct possibility. Saudi Arabia could come under pressure. The most negative near term result of this split would be OPEC's refusal to increase oil output, despite the rising price, something similar to the situation after the Yom Kippur War in 1973. - John Taylor

As we have been highlighting for quite a while, the 5th member of the PIIGS, Italy, has emerged very much unscathed so far from the European sovereign debt fiasco. Is that merited? Not according to famous euroskeptic Nigel Farage, who gives another unvarnished, and uncensored interview with RT, in which he lays out his reasons for why a plunge in Italy bonds has at best been delayed.

The fundamentals of the last PIG country, which has so far avoided the bond carnage of its peripheral peers, reported that while broad unemployment was 8.7%, the "highest since the beginning of the beginning of the time series in 2004" it is youth unemployment which, like in Spain, is becoming a few bigger issues. Corriere Della Sera announced that youth unemployment has hit a record of 28.9%: "Youth unemployment, however, did rise as the rate climbed to 28.9%, up 0.9 percentage points on October and 2.4 points higher than in November 2009. This, too, is the highest level since time series were introduced in January 2004." Yet even at these levels, this is still modest compared to countries like Spain, where the same metric was trending around 40% and is expected to remain there through 2011.

The dominoes are starting to fall ...

The traditional hot bed of haute couture and fashion retail is experiencing an unprecedented plunge in end demand as Italy, absent trillions in fiscal and monetary stimulus boosts, has become a prime example of what US retail would look like absent the generosity of the government and the Fed. According to this Bloomberg TV report, "sales are worse than last year and business is getting worse and worse. The situation is not good." Summer sales revenues are expected to be down 5% across the board. Another factor blamed for poor sales: the weak performance by the Italian football team, and the resultant glut of jerseys. And when Prada and Gucci are seen offering extra discounts just to get shoppers into the stores, the whole concept of ultrapremium retail goes out of the window, putting the "aspirational shopper" paradigm on hold.

Greece was the standout in Europe (and in fact across most sovereigns) with a 60bps decompression today (closing below 1000bps but managing to get above and trade handily upfront for much of the day). This is a 200bps decompression since the roll and while volumes remain marginal, bonds have weakened with the 2-5Y range inverting even more significantly. Calls for 50% haircuts on Greek sovereign debt in the stress tests, and an increasingly glib view of the effectiveness of the stress tests saw FINLs shift wider once again with SEN and SUB moving pretty much in line and notably FINLs and ExFINLs not decompressing. This is interesting as perhaps we are seeing the contagion leaking back into non FINLs (which would make sense via direct channel from lending/credit as well as indirect via austerity/growth slowing).

Just Reuters headlines for now: all Europe needs is another risk flare up.

The idiocy in Europe knows no bounds. Just as the EURUSD was about to stabilize a little, and we use the term very loosely, Italy comes out and announces that due to its Robin Hoodesque task of rescuing Greece, and the need to shore up even more liquidity, that it would increase its bond issuance to €240-250 billion. As Market News reports: "Italy’s contribution to the EU’s Greece aid package is E14.736 billion out of a total E110 billion package from the EU and IMF, under the three-year economic and financial policy program. This year’s contribution is estimated to be around E5.4 billion. The first tranche of this loan E2.921 billion was paid in early May." Alas, unlike in the US where every new trillion in bond issuance
somehow results in a 50 bps tightening in the 10 year, Italy is not
quite so lucky. The result of this announcement: new all time high for Italy 10 year Bund spreads at 173 bps. And it doesn't end there: Reuters has just reported that talks between Sarkozy and Merkel, previously scheduled for today, have been rescheduled for June 14 (and probably cancelled as the two European leaders can't stand each other any longer) - is it all now falling apart in Europe behind the rosy rhetoric?

MarkIt reports Italian CDS has exploded by 50bps, from 200 on Monday to 250bps, a new record. The weakness is spreading globally now. A slightly delayed CMA report indicates that the biggest CDS movers are all sovereigns, and led by Korea and other Asian names. In the meantime eurodollar futures are pushing ever higher, even as Libor is still testing the temporary breaks at 0.53%. All fine and dandy, until you look at Euribor, where things are getting surreal. We will discuss this shortly.

Libor is now at 0.53%, eurodollars are plunging, new Fed-ECB rescue facilities are rumored to be imminent, Germany is set to introduce a ban on naked shorting of all stocks, and sovereign risk is exploding: it will be a fun day. Spain, Italy and Korea are all more than 20% wider on the day, as the contagion virus is spreading faster and faster toward the heart of Europe.