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 spoke this afternoon and the financial markets were 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?
The Fed announced that it would sell $400 billion of short-term bills and notes and buy $400 billion of six- to 30-year bonds in an effort to drive down long-term interest rates and boost the economy. That was certainly at the aggressive end of predictions for what the Fed would do.
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 was 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 US economic growth, but an announcement of a smaller than expected buying program—or none at all—would have caused some bond buyers to unwind their bets. That would have sent Treasury yields higher and, probably, pushed down stock prices modestly.
Ironically, since bond buyers have already built Operation Twist into bond prices, an announcement of the beginning of the program will probably have the same effect on bonds at least for a few days—although it would probably support stock prices, at least for today.
After initially falling on the announcement, the S&P 500 picked up 16 points in the half hour from 2:30 to 3 p.m. ET.
This is actually small potatoes as far as market-moving news goes. It’s getting so much attention only because we’ve got a respite (until the weekend IMF 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.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any stock mentioned in this post as of the end of June. For a full list of the stocks in the fund as of the end of June, see the fund’s portfolio here.
