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Is Italian Bond Selloff Becoming Self-Fulfilling?

Events on Wednesday could prove crucial to attempts to again come to grips with the European debt crisis, after Italian borrowing costs hit a 14-year high on Tuesday.

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Italy, the euro zone’s third-largest economy, finds itself at the mercy of bond vigilantes and hoping that the much talked about resolve of EU authorities can turn things around. Shares of the country's banks have fallen sharply lower since the start of July.

Following a widely reported battle over spending with his economy minister, Silvio Berlusconi will this afternoon address both houses of Italy’s parliament after European markets close, in an attempt to calm investors and convince the Italian people that he remains the best man to lead Italy out of its problems.

Berlusconi’s speech, just before US markets open, will undoubtedly add some drama to the session, but the more important event could well be Italian economy minister Giulio Tremonti’s meeting with Jean-Claude Juncker, the chair of the euro group, in Luxembourg.

Again and again we have heard that speculators should not underestimate EU leaders' resolve to protect the euro project but time and again we have witnessed disagreements between individual countries and Jean-Claude Trichet’s European Central Bank that allow speculators a free hand to short the sovereign debt of Greece, Ireland, Portugal and now Italy and Spain.

“No significant news is driving the increase [in bond yields], and this looks more like a vicious cycle that is difficult to halt. Exactly three weeks ago we saw a similar market movement that was halted by reports that both the ECB and China were buying,” Anders Møller Lumholtz, an analyst at Danske Bank said in a research note.

“If the rise in yields continues, the likelihood of ECB intervention increases significantly,” Lumholtz said.

ECB intervention could well see market sentiment turn against the shorts targeting Italy’s sovereign debt and stock market, but Jean-Claude Trichet will on Thursday be asked at the monthly ECB press conference just what it will take for him to dip into the central banks' Securities Markets Program to try and regain control of market sentiment.

“If we do not see a reversal of Tuesday’s increase, we expect EU leaders once again to express their commitment to halt the debt crisis. Also, the ECB council members are likely to start emphasizing that the risk of contagion prevails, despite the euro area leaders delivering a second aid facility to Greece.” said Lumholtz.

Others, however, doubt whether the euro zone leadership is likely to unveil a new policy over the summer months when many will hit the Mediterranean for some sun.

“The sheer volatility of the moves is feeding on itself and does not give much confidence to investors to oppose the moves. There might be some announcements in the coming days, including in the planned speech on Wednesday by PM Berlusconi, although we would not expect any new policy initiative at this stage,” Laurent Fransolet, the head of European fixed-income strategy at Barclays Capital in London, said in a research note on Wednesday.

“It is difficult to see what kind of circuit breaker is needed to change the current (self-fulfilling) environment. ECB and EU officials are unlikely to announce anything in the very near future, despite the ECB meeting on Thursday” Fransolet said.

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