Greece sneezes. Will Italy catch a cold?

Greece’s surprise call for a referendum on its new bailout deal dashed hopes that the latest plan of attack for the euro zone would soothe sickly financial markets. It also set off some warning bells in the bond market that could again ratchet up the pressure on Italy.

Italian debt was hit hard by the referendum news, particularly at the short-end. Ten-year yields also rose sharply to 6.37% — the highest since August, when the European Central Bank (ECB)  first began intervening in the secondary market. Analysts flagged the dangers of a bear flattening in the Italian bond yield curve.

Rabobank says, “The Italian curve rapidly morphs into a credit curve the like of which preceded previous bailouts. Clearly, time is rapidly running out in terms of drawing a line under the crisis - not least owing to the fact that Italian yields are very quickly moving into territory where its ability to finance itself is in question.”

Nick Stamenkovic, strategist at RIA Capital Markets, echoed the sentiment: “If we continue at this pace we will be going down the same route as Greece, Ireland and Portugal and then they will have to come in and support Italy.”

The European Central Bank will have to up its bond-purchases if it wants to prevent Italian yields from rising towards 7% — a level beyond which funding costs are perceived as unsustainable, analysts said.

Equity markets also took a spill as risk-aversion made a comeback. European stocks fell more than 3%, Bund futures rallied more than 300 ticks at one point and peripheral bonds struggled.

As analysts at Capital Economics put it: (The referendum) clearly increases the risks both of a bigger and disorderly default on Greek debt and, ultimately, of Greece leaving the euro.
Gary Jenkins of Evolution Securities called it a “political gamble”:

Prime Minister George Papandreou will be hoping for a vote in favour to strengthen his mandate, but if the Greek population votes against, it will leave the IMF and Greece’s European partners in a very difficult situation and seriously increase the risk of an exit from the currency union.