The Fed, Greece and Italy, oh my!

09/21/2011 1:11 pm EST


Jim Jubak

Founder and Editor,

It takes a bit to upstage the Federal Reserve but I think Italy has managed it. Even though its news opportunity is more than a week away.

Sure, the Fed is set to speak this afternoon and the financial markets are on tenterhooks about “Operation Twist.” Will the Fed, won’t the Fed, decide to sell short-term bills and notes from its portfolio in order to buy long-term bonds? And how aggressively will it shift the duration of its portfolio in order to drive down long-term interest rates?

But next Thursday, September 29, Italy could set off a full-scale, domino-tumbling panic in European bond markets if its auction of government bonds fails. An auction failure could even overwhelm the European Central Bank’s ability to support the prices of Italian and Spanish government bonds.

The Fed’s Operation Twist is a top-of-the-marquee market-moving event only because financial markets have priced it into the long-end of the Treasury market where prices have been climbing and yields falling in anticipation. Nobody really expects that the move would do much to actually stimulate U.S. economic growth, but an announcement of a smaller than expected buying program or none at all would cause some bond buyers to unwind their bets and that would send Treasury yields higher and, probably, push down stock prices modestly. Ironically, since bond buyers have already built Operation Twist into bond prices, an announcement of the beginning of the program would probably have the same effect on bonds—although it would probably support stock prices, at least for today.

This is actually small potatoes as far as market-moving news goes recently. It’s getting so much attention only because we’ve got a respite until the weekend International Monetary Fund meeting in Washington on news from the Greek debt crisis.

It will be interesting to see how quickly financial markets move from the Fed and Greece to Italy—because next week’s Italian bond auction has far and away the most potential to disrupt the markets.

In the last auction of Italian government bonds at the end of August the bid-to-cover ratio, a measure of how much demand there was for the bonds being sold, came in at just 1.27. (That means there were buyers for 1.27 times as many bonds as were available for auction.)

The bid-to-cover ratio has been gradually slipping at Italian bond auctions and August’s ratio was dangerously close to a 1.00 bid-to-cover ratio. Anything below a ratio of 1 indicates that not enough buyers turned up for the bonds on auction. And anything below 1 is considered an auction failure.

In all likelihood the yields at the auction will climb high enough to generate a bid-to-cover ratio above 1 and thus avert an out-right failure. But if the bid-to-cover ratio slips further from August’s low, you can expect bond markets to get even more nervous about Italian debt.

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