An unconditional promise from the European Central Bank (ECB) to be the buyer of last resort for Italian bonds would provide reassurance to the market, according to Russell Investments chief investment strategist Andrew Pease.
However, if the ECB does not commit to large-scale Italian bond purchase then the markets will continue to freefall, he said.
"Rising bond yield make investors worried about Italy’s ability to repay its near $2 trillion of outstanding debt. As a result investors demand higher interest rates on Italian bonds, marking them even more concerned about Italy’s ability to repay," Pease said.
According to Pease, Italy’s main problem as opposed to Greece’s is one of solvency. While Italy has a debt-to-GDP ratio of 120 per cent, its primary fiscal position indicates revenues are almost equal to spending. This makes the debt manageable at current interest rate levels. However, if yields continue to rise beyond 7 per cent Italy becomes effectively insolvent.
Pease said if the crisis continues to escalate the ECB would have no other option than to act as the buyer of last resort. "While it won’t mean the end of Europe’s problems by any stretch, it will mean that the risk of an uncontrolled illiquidity-driven crisis is effectively over," he said
Russell thinks the biggest risk facing the US is Europe pulling down the banking sector. Going forward Pease thinks that eventually (sometime after 2013) the housing market could be the trigger for growth there and provide the kick-start to the rest of the economy, with demand stimulating other parts of the economy such as infrastructure and utilities.
Locally, Russell is more cautious on the rationale for lower interest rates and sees this as very much driven by employment trends. "We’d expect another cut if employment continues to trend lower post the slowdown in GDP growth we witnessed in the first half of this year."
