How Italy’s Debt Affects the Dollar and Risky Assets

by Jason Jenkins, Investment U Research
Thursday, November 10, 2011

Fear abounds that if you let Greece fail, then a contagion of sovereign debt default will spread across the Eurozone.

But Greece doesn’t have to fail for this to happen. The lack of structural soundness – no actual Eurozone Treasury – has already seen to that.

Let’s not forget the dysfunctional governments of the PIIGS (Portugal, Italy, Ireland, Greece and Spain). We’ve seen bailouts of almost all of them, with Italy now on the brink. Italian bond yields were the primary concern Wednesday morning after clearing firm LCH. So much so that Clearnet raised its margin requirements for Italy’s government debt.

Italy’s Debt Level is Unsustainable

The 10-year yield hit the point of no return: seven percent. This mark is viewed by many as the barrier in which Italian borrowing costs become unsustainable.

Why, you ask?

Well, the seven-percent level was effectively a point of no return for Greece and Portugal earlier in the Eurozone crisis. This level shut those countries out of credit markets and forced them to seek bailouts from the European Union and International Monetary Fund.

However, Italy is a different animal altogether. It’s common knowledge between strategists that the Eurozone’s third-largest economy is too large to bail out – at least in the Eurozone’s current structural form. Doubts remain if a new and improved European Financial Stability Facility will have the capacity to serve as a competent firewall.

Not Just Berlusconi

All this comes as the controversial Italian Prime Minister Silvio Berlusconi stated Tuesday of this week that he will resign after parliament approves austerity measures for its 2012 budget.

“This is getting scary,” said Louise Cooper, markets analyst at BGC Partners, in emailed comments. She said traders are betting against Italy because they see a country “seriously threatened by its enormous debts.” She went on to say, “Whether Berlusconi stays or leaves, the Italian political structure is almost incapable of dealing with the country’s problems.”

Deja vu all over again. This sounds like Greece’s story over the last two years, with more frightening consequences.

What it Means for the Dollar and Risky Assets

The crisis in the Eurozone looks like it will be a prolonged and painful process, which doesn’t look good for a global economy struggling to get back on its feet. Yet, this scenario can turn out to be the dollar’s best friend. And at the same time, the landscape will add to the volatility of risky assets globally across the board.

The Eurozone sovereign debt crisis is just beginning. This has and will allow the dollar to be the default global reserve currency. We have our own problems, but we look a lot better than Europe, and here are the main two reasons why:

U.S. Treasury bond yields still remained relatively lower even with a Standards & Poor’s rating downgrade, low job creation, a historically depressed housing market and unemployment over nine percent.

The Dollar Index held its own even when the U.S. government had record debt.

On the flip side, we historically see a relationship between the dollar and equities and commodities. A strong dollar usually indicates a tightening of global liquidity, which leads to risky asset sell-offs – think back to a few years ago after the banking collapse.

The take is to be strong on the dollar and expect the euro to see major problems in the future.

Also, this is the time to look for investment opportunities in companies with strong cash positions who have substantial or growing footholds in emerging markets. Growing sales and wealth in emerging markets should outshine any developed economies’ geopolitical and debt issues.

Good investing,

Jason Jenkins

Article by Investment U