An Update on Italy and Spain

On January 5th I wrote on building a case for the relative out-performance of Italian bonds (Why Spain may be more Worrisome than Italy). This was a contrarian view as many feared that the combination of Italy's own poor debt dynamics and the contagion from the periphery were putting the third largest country in the euro zone at risk. Various commentary and analysis played up the under-performance of Italy compared with Spain in the bond market, rising cost of insurance (in the CDS market) and the threat of more action by the rating agencies.

Since that January 5th note through today, the Italian 10-year yield has fallen 147 bp to 5.62%. The Spanish equivalent yield has fallen 66 bp to about 4.98%. Similarly, Italy's 2-year yield has fallen 192 bp to 2.95%, while Spain's 2-year yield has fallen 107 bp to 2.58%.

The markets have rewarded Italy for two reasons:

First, Prime Minister Monti has won the support and confidence of investors through his reform agenda. Even Berlusconi has lent support to most of Monti's agenda.

Second, the ECB's 3-year lending facility has also reduced the extreme tail risks that were perceived in Q4 11. Investors were prepared for the worst and when this failed to materialize, investors were forced to get involved again or face a significant under-performance relative to benchmarks. It has also helped that the EBA has reportedly indicated that last year's stress test that included marking to market sovereign holdings will not be repeated in this year's tests.

Spain has benefited from some of these developments too, but it has been hampered by a couple of Spain-specific developments, including the large deficit overshoot last year and a seemingly public debate between the budget and finance minister over the ability to meet this year's fiscal targets.

While Spain is encouraging additional bank mergers, and this may buy some time to meet capital requirements, Italy's banks have already swallowed some tough medicine. Unicredit, Italy's largest bank, for example, has rallied more than 12% and is off only about 1% from its pre-rights issue price.

More broadly, Italian shares are outperforming Spain. The FTSE MIB Index is up 8.3% compared with a 2.6% rise of the IBEX 35 Index.

Ahead of the next LTRO at the end of the month, Spanish and Italian bonds may begin consolidating after the large moves seen over the past month. The scope for Italian out performance in the month ahead appears somewhat more limited than over the past month. Indeed, the 5.5% yield level on Italy's 10-year generic bond may prove a bit sticky. It also corresponds to trend lines on the weekly charts, drawn off the yield low of 3.7% in mid-Oct 2010. Spain's 10-year yield decline is slowing as it slips through the 5% threshold.