Bond Auctions Continue To Dominate Forex Trading

Includes: FXE
by: Zecco

By Paul Quintaro

European bond auctions have contributed significantly to the movement of the markets in late 2011.

On Thursday, the eurozone had yet another auction—this time in Italy. Commentators were mixed on whether or not they considered the results of the auction to be a success.

The Italians were unable to sell as much debt as they had hoped to—a negative. But on favorable note, the borrowing costs for the debt they did sell came down to a more favorable level.

Italy’s new Prime Minister Mario Monti held a press conference following the sale, in which he addressed the bond market.

Monti declared that there was no fundamental reason for Italian yields to remain high.

Somewhat ironically, had it not been for the yield spread being at elevated levels (which Monti criticizes) he probably would not hold the position he holds today.

When yields on the Italian 10-year moved above 6%, everything quickly came under fire. The long-serving Silvio Berlusconi lost his position in short order, as the “technocrat” Mario Monti was put into the Prime Minister position in the hopes that he would be able to quickly reform Italy’s finances and bring confidence to the debt market.

There were reports that the European Central Bank had been intervening in the Italian debt market, purchasing a modest amount of Italian debt to boost demand for the bonds and bring down yields.

The ECB’s role in keeping yields on Italian debt subdued is somewhat murky. The ECB has reportedly been actively intervening in the market for quite some time, although they have yet to truly step up with a massive program or a guaranteed backstop.

In the U.S., the Federal Reserve is the official “lender of last resort.” The ECB carries no such title, and many in Europe hope that it never does.

If the ECB were to take on that mantle, and effectively monetize the debt of the troubled eurozone nations, it could lead to significant inflation in the eurozone, as the value of the euro is diluted through the printing operations of the ECB.

Inversely, if the ECB does not keep bond yields down and monetize some debt, then the euro could cease to exist as a currency, as the indebted nations—like Italy—default and withdraw from the currency union.

The EUR/USD pair was trading near $1.29 on Thursday. It had broken below $1.29 early in the morning before rallying back later in the day. Volume was subdued during the shortened week, and may have played a role.

The Italian 10-year stayed right around 7%—a key level it has been holding near. If that yield spikes higher, traders may anticipate further weakness in the euro.