One day after European leaders announced a series of measures aimed in part at enticing investors back to the region's debt markets, bond buyers demanded higher yields on Italian and Spanish debt. An auction of new Italian bonds was met with weak demand, forcing the nation to pay higher interest rates than in previous sales.
The wan response from bond markets underscores how challenging it will be for European leaders to convince financial markets that Thursday's broad agreement is sweeping enough to enable troubled countries such as Italy and Spain to work their way out from mountains of debt. The plan calls for beefing up the region's bailout fund, recapitalizing banks and reducing Greece's debt burden.
With European leaders finally hammering out a deal on the region's debt crisis, David Wessel on The News Hub looks at the risks that remain and why they can spillover to the U.S. economy and markets.
Stock markets across Europe gave back some of Thursday's big gains. Italy's stock market closed down almost 2% and Spain dropped about 0.5%. In the U.S., the Dow Jones Industrial Average edged up 0.2% to close at 12231.11.
Bond markets are a more important audience for Europe's governments: It is there that financially strapped nations must turn to borrow money. On Thursday, when many stock markets staged strong rallies, bond markets were lackluster. Yields on Italian and Spanish debt declined, meaning their prices rose, but only slightly.
On Friday, attention focused on Italy. The nation is saddled with €1.9 trillion in debt, with more than €200 billion of it coming due next year. Some investors worry that unless Italy lowers its borrowing costs, it could become the center of a renewed flare-up in the crisis.
In Friday's bond auction, Italy was forced to pay more than 6% interest on its new 10-year debt, approaching levels that some analysts said the country can't afford for long.
"Italy remains a big problem," said Alessio de Longis, a portfolio manager at OppenheimerFunds. Italy has been failing to deliver on promises, he said. Instead "it's only talk—chiacchiere in Italian," he said.
Under pressure from euro-zone authorities, Italian Prime Minister Silvio Berlusconi has pledged to pass measures aimed at reigniting the country's stalled economy, including reforms to Italy's labor market and pension system.
On Friday, Mr. Berlusconi noted the rising borrowing costs would "further damage our finances."
But the prime minister faces significant hurdles in gaining approval for his plan to boost growth. He not only needs to persuade his fractious cabinet to sign off, but also the Italian Parliament, where he has a thin majority.
"The truth of the matter is that the issues are not entirely resolved," said Steven Walsh, chief investment officer at bond manager Western Asset Management, which oversees $433 billion. With this week's agreement, European officials "are addressing the important issues…but the biggest caveat out there is Italian and Spanish debt, where you have not seen a response that 'this is game-over, this is perfect.'"
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Despite the bond market's skepticism, many investors and analysts said Thursday's agreement is likely, for now, to prevent a serious escalation of the crisis, which could have tipped the global economy back into recession. They said the effort to shore up the finances of Europe's banks was an important step in addressing a problem that many officials had until recently denied existed.
Still, bond investors see plenty of reason to remain wary. One basic question is whether the plan to expand the bailout fund, known as the European Financial Stability Facility, will succeed.
Under Thursday's measures, the EFSF would "backstop" countries such as Italy should they not be able to finance themselves, as well as offer investors a partial guarantee against losses on government debt.
Uncertainly persists on both of those fronts, especially if Italy gets shut out of the bond markets by investor demands for even higher interest rates, which happened to both Greece and Ireland.
"The firepower of this fund…is not enough to calm fears," said Silvio Peruzzo, an economist at RBS Global Banking & Markets in London.
Some investors also are skeptical of the plan to use the EFSF to insure against losses on government debt. Under the agreement, the EFSF would absorb the first 10% of losses on debt issued with the insurance. Investors figure that if losses amount to 50%, which was the case with Greece, that wouldn't provide enough protection.
"If you had the 10%, it wouldn't help much," said Western Asset's Mr. Walsh.
Another question: To what extent will the European Central Bank be the buyer of last resort for sovereign debt? The ECB started buying bonds of indebted European governments in mid-2010. After an 18-week pause, it restarted the program in August as the euro zone's debt crisis spread to Spain and Italy. But influential voices within the ECB, in particular in Germany, want to end the program.
Bond investors also are worried about the potential for a European recession. RBS's Mr. Peruzzo said a recession "will be much more severe on the countries struggling to get their public finances in order." That could make it more difficult for some countries to reduce their budget deficits, which, in turn, could lead to addition downgrades in their credit ratings.
Those sorts of concerns played out in Italy's €7.935 billion debt sale on Friday. On each of the four bond issues it sold, Italy was forced to pay higher yields than in the recent past. Most significantly, 10-year debt—a market benchmark—was sold at a yield 6.06%, up from 5.86% only a month ago.
"With a 120% debt-to-GDP ratio and 10-year Italian bonds yielding roughly 6%, they can't do that forever or the borrowing costs will get to an unsustainable level," said Eric Stein, portfolio manager at the Eaton Vance Global Macro Absolute Return Fund. "As your rates go up, it means you're paying more and more to service your debt, and your whole debt dynamics become harder and harder and harder."
—Emese Bartha and Stacy Meichtry contributed to this article.
Write to Tom Lauricella at firstname.lastname@example.org and Matt Phillips at email@example.com
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