While economic data out of the US has continued to improve in recent weeks (especially the employment data), the economic situation in the Euro-area remains extremely concerning.
After the EU summit on 8/9 December 2011, the EU leaders announced the establishment of a new "fiscal compact", which aims to better enforce fiscal discipline within the region. However, the details of the new treaty are still vague and only expected to be finalised in March 2012 (at the earliest). This means that there remains a significant risk that the financial markets will remain relatively volatile in the first part of 2012, especially if growth rates continue to soften.
There is also a real concern that the higher cost of refinancing sovereign debt will derail the ability for key governments (especially Italy) to effect the necessary fiscal discipline. Under the leadership of Mario Monti, Italy has adopted a severe austerity package aimed at eliminating its budget deficit by 2013 (it has run a growing primary budget surplus since last year). Nevertheless, the Italy 10-year bond yield is currently above 7%, implying that the market remains unconvinced. The ECB eased back on its bond purchases in late 2011, which may partly explain the recent rise in yields - see chart attached.
Unfortunately, Italy has a huge gross financing requirement of €440 billion for 2012, with about €130 billion in the first quarter. Should Italian bond yields remain at current levels, or move higher, the increased cost of borrowing could start to swamp the budget, and effectively undermine the government’s ability to implement a managed and orderly path to fiscal discipline.
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