This story just hit Bloomberg news service ("Spanish Treasury to Exclude Italian Government Bonds"). If true, it represents a real threat to the long term sustainability to the European monetary project. The credit crisis, strong euro and slowing economies are finally starting to test the patience of European policy makers. Since the inception of the Euro back in 1999, European Central Banks never distinguished between the credit quality of the various European Sovereigns. That meant that Italy for example could raise funds via debt issues at terms close to those of Germany even though Italy's financial house is in very different order from that of Germany. It was a classic misallocation of credit risk. That's all set to change and Italy's funding costs could skyrocket. Belgium, Portugal and Greece and potentially all in the same pickle. The immediate trade that comes to mind is to short Italian debt versus German or shorting the Euro, which is perhaps the most overextended against the Yen.

John Floyd adds:

All that makes sense. Italy has lost roughly 30+% of competitiveness over the past few years and has also, wisely, extended their debt maturity, not to mention their other weak macro fundamentals. The extended debt maturity would also, should they choose to do so, make it advantageous for them to leave the Euro. The sovereign spreads are all still priced fairly tight with 50 bps of each other for 5-10 year maturity. Compared to where Italy, etc. were during the EMU crisis at many hundreds of bps. I would consider higher grade corporate to be long against short the weaker sovereigns, this also has positive carry.





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