Watch Eurozone Interest Rates

by: John Dalt

Italian interest rates spiked Wednesday to over 7%. The market went into hyperventilation mode, selling everything except mom’s kitchen utensils. We had the biggest one day loss on the DJI since August. Why? Because the talking heads say 7% marks the point of unaffordability for nations to pay off their debt.

Really? There will be a time when 7% will look cheap. A time when being able to borrow money at 10% is considered a “deal.” I know, I have seen me do it! Doesn’t anyone remember the gaiety and excitement of Jimmy Carter and stagflation?

Actually, the sellers didn’t sell everything, volume wasn’t that heavy. What happened was buyers backed away from the market once the avalanche started. Kind of like getting out of the way of a wreck, it is better to watch from a distance.

When Greek interest rates hit 7% last year, it signaled the end of their ability to sell debt on the open market. Greece’s situation is worse than Italy, because they are running a larger budget deficit. Italy doesn’t have to sell that much debt, but they have a large amount outstanding.

They will have to sell debt in the future to pay off maturing securities. While Italy could afford to borrow a small amount at higher interest rates to fund government operations, refunding existing debt at higher rates will add additional pressure to the government budget.

Nouriel Roubini told Forbes that Italy will be forced into bankruptcy and exit the eurozone if the European Central Bank does not engage in massive quantitative easing. Roubini argues the ECB has to drop interest rates and purchase sovereign debt to lower interest rates for sovereign debt and kick start the European economy.

Italy was able to sell $7 billion dollars worth of one-year notes Thursday morning at 6.087% The ECB was reported to be the major buyer at the Italian bond sale.

This calmed equity markets Thursday and Friday. But did the storm really pass? Prime Minister Silvio Berlusconi promised to quit after austerity measures passed the Italian parliament. Bond clearing house, LCH Clearnet raised the margin requirement of Italian debt Wednesday. This increased the volatility in Italian bonds.

What happens when the Rescuers need Rescuing?

Thursday morning the bleed off occurred. French debt spiked higher, with spreads over German Bunds reaching 150 basis points. Standard & Poor’s reiterated France’s AAA credit rating, but for how long? French banks BNP Paribas and Credit Agricole hold a total of $416.4 billion dollars in Italian debt.

Italy needs to borrow at least $90 billion dollars in the next four months. Where does the money come from if France looses their AAA credit rating? Italy has the world’s eighth largest economy with the third largest sovereign debt.

Eventually, the Germans may be confronted with rescuing all of Europe. When and if this happens, equity markets will be devastated. We are optimistic the stock market wants to move higher on the short term, but the dangerous eurozone debt fires are burning brighter on the horizon.

A side-note that should scare the “super committee”: Wednesday the U.S. Treasury auctioned $24 billion in 10-year bonds. Thursday $16 billion in 30-year bonds were sold with the second lowest demand for U.S. Treasuries in the past year. Friday saw “lackluster” demand, according to Reuters. U.S. interest rates are higher this week than last. Oops.

The future looks bleak. After Italy comes France ... and then the U.S.?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.