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Contagion & Italy

  • Italy’s yield curve is not inverted. An inverted yield curve signals recessionary conditions. During a recession fiscal revenues decline and expenditures may rise. An inverted yield curve would suggest a weakening of the sovereign’s ability to repay lenders, thus potentially prompting higher risk premiums.     
  • The default risk premium of the sovereign’s credit is not excessively high. Italian 10 - year treasury bond yield is 5.56%. A yield over 6-7% during deflationary to moderate inflationary conditions is an unsustainable level of borrowing costs.  
  • The austerity package in the Italian parliament prompted a risk averse reaction from investors in financial markets. A decrease in fiscal expenditure is a GDP negative. Government spending is a component of GDP. Slower growth results in investors demanding higher risk premiums for lending and investing; particularly in poorer quality issues.
  • The aforementioned facts suggest that contagion has not yet spread to Italy and the reaction in financial markets is more likely due to the austerity package being debated in the Italian legislature.