Italian sovereign debt now trading more like a real market

Despite a lot of the fear, anxiety, and gloom about European debt, the good news about higher yields on Italian sovereign debt is that now that debt is actually finally starting to trade like a real market where participants are actually pricing in perceived risk, whereas previously there was the "moral hazard" of an implied guarantee on 100% of the par value of that debt. Before the EU deal with Greece was arranged, people still assumed that the EU would guarantee all sovereign debt of EU members at 100% of face value, but now that the EU is essentially valuing Greek debt at a 50% discount, which was basically negotiated with the big European banks, the so-called "bond vigilantes" are jockeying to determine what "haircut" the EU will apply to Italy's sovereign debt. This is a really good thing. Properly pricing risk is essential to a healthy market and financial system.

 

If there is one paramount lesson from the current European Debt episode it is that moral hazard is still a very real and significant concern and can be ignored only at the peril of all concerned.

 

Personally, I don't see a 7% yield on Italy's debt to be outrageous or unwarranted or a true "crisis." Hey, if that's the value the market puts on it, so be it. If Italy doesn't like it, then they should stop issuing debt and buy it back. This is and should be all about the market providing an economic feedback signal to a debt issuer.

 

The other pragmatic factor here is that a lot of the rise in yield is really due to European banks dumping Italian debt to clean up their books and balance sheet in anticipation of whatever haircut the EU might force on them. That's as it should be. Yes, it causes some significant anxiety, but that's as it should be. And that's a whole lot better than where we were in recent years where the moral hazard of 100% bailout was masking true economic signals. Economic signals are everything when it comes to finance.

-- Jack Krupansky