No more bunga bunga, but bonds are still high

THE European political machine flexed its muscles last week, first in Greece and then, more significantly, in Italy.

A nudge from its European benefactors was enough for Greece to topple its prime minister George Papandreou after months of pressure and confidence votes. The Greek parliament moved to appoint a man who ticked all the European boxes – former European Central Bank vice president Lucas Papademos – along with a new coalition cabinet. In doing so, it is hoped that the next tranche of aid will be approved on the nod – avoiding a Greek default on its debt payments due at the end of this year. “In our view, this is an encouraging development,” says Willem Sels, UK head of investment strategy for HSBC private bank. But Sels adds that this is in no way the end of Greece’s problems: “The debt mountain the country faces is still prohibitively high – even after the voluntary restructuring with the banks has been completed, the debt-to-GDP ratio is estimated at 120 per cent.” With these levels of debts, with very few signs of growth on the horizon, it is difficult to see how Greece will dig itself out of its problems.

But while Greek debt is seen by everyone except Jim Corzine as a write off, events in Italy are much more difficult to judge. After a week where its bond yields surged to seemingly irredeemably high levels, Italy made the decision to sacrifice its prime minister on the altar of the international debt markets, perhaps in the hope that some of his potency might perk up its economic outlook. Though the sacrificial dagger was wielded by Italian hands, they were strongly guided by European policy makers. Mr Berlusconi has been replaced with technocrat Mario Monti, but yesterdays markets showed little sign of faith in the new regime – in yesterday’s 5-year bond auction, interest rates were at 6.29 per cent, up from 5.32 per cent – indicating that significant perceived risk remains.

When it comes to trading the current situation, as Colin Cieszynski, market analyst at CMC Markets points out, with both political and economic progress heavy going, it’s difficult for either bulls or bears to have the courage of their convictions: “Just as it took years to get into this mess, it’s going to take years to get out of it,” says Cieszynski. “Although there are signs of late that key corners have been turned, there remains the potential for hiccups and potholes on the road to reform and recovery.” In the short term, there may be a temptation to hedge your bets by taking a position on volatility, but David Jones, chief market analyst at IG Markets advises taking a position directly on Italian bonds – it has the highest liquidity and lowest spreads of any potential CFD options.

If the continuing failure of ECB purchases of Italian bonds to gain any traction is anything to go by, betting against Italy seems almost as attractive a proposition as an evening with their former leader’s special friends.