Big Bazooka Talk Keeps Investors on Edge

After a week that saw stocks fall heavily and euro zone borrowing costs rise sharply, a report in the Italian press highlighted just how eager for some kind of action the market is.

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On Sunday, Italian daily newspaper La Stampa reported that the International Monetary Fund was considering launching an aid program with enough cash to support nearly half of the Italian bond market, sending stocks in Asia sharply higher.

The subsequent denial from the IMF that it was in talks with Italy about an aid program saw gains pared.

As one analyst told CNBC on Monday, the rather detailed report, which predicted support of between 400 billion and 600 billion euros ($798 billion) of aid from the fund for Mario Monti’s new economy, was probably simply a proposal paper which had been leaked, rather than a plan that was seriously on the table.

With more austerity measures reported to be on the way for Italy and its voters, Barclays Capital have said that the euro zone’s third largest economy looks increasingly likely to require outside support.

“Italy is unlikely to stabilize on its own as the size of its debt leaves it heavily exposed to changes in market sentiment in a context where self-reinforcing negative market dynamics are difficult to break with domestic policies alone,” Fabio Fois, a European economist at Barclays Capital wrote in a research note following the La Stampa report.

Rather than completely remove Italy from the market, Fois believes the authorities should focus on protecting Rome’s access to international markets.

“With the IMF unlikely to have the resources, the EFSF and more importantly the ECB are likely to be involved as well,” Fois said.

Rising Borrowing Costs

A disappointing German Bund auction last week added to fears over euro zone debt crisis while a downgrade of Belgium’s debt late on Friday added to the sense that the authorities where again losing control of market sentiment, if they have ever had control that is.

The weekend press was full of reports of what Angela Merkel and Germany are demanding to in order for funds to help solve the debt crisis.

A new stability pact, a new Treaty, fiscal union, common corporate tax rates whilst holding countries to account but no joint Eurobonds or change of role for the ECB.

France and Nicolas Sarkozy have had to stand side by side with Germany and its reluctance to allow the ECB to start hovering up huge amounts of euro zone debt.

Behind closed doors officials in Paris will be nervously watching their own borrowing costs move higher.

“Lower growth means public debt will keep growing.

The euro zone crisis has spread from the periphery to France, despite the austerity measures which the country announced on 24 August and 7 November,” said Mathilde Lemoine, a French economist at HSBC in a research note.

With yields rising, Lemoine is worried that it may now be difficult to stabilize France’s debt to GDP ratio and believes higher borrowing costs in France strengthen Germany’s hands in any talks over the future of the euro.

France “will have to accommodate Germany in this area and accept the principle of federalism and fiscal control.

In return, it will want the ECB to expand its balance sheet to help stabilize the crisis – something Germany has so far resisted,” said Lemoine.

“This will force France to introduce fresh austerity measures; although those already announced will help slow the growth in public spending, they are still insufficient, given lower growth expectations and higher interest rates,” she added.

In for a Banking Crisis?

European finance ministers will meet yet again in Brussels this week.

Talk of new treaties and more austerity are likely to dominate as reporters push for off the record briefings on possible big bazookas.

Carl Weinberg, the chief economist at High Frequency Economics believes the IMF’s major backers like the US and Japan are unlikely to support the fund throwing hundreds of billions at Italy or the euro zone.

He remains very bearish and sees banks failing by the end of the year, if not before.

“We do not think this spells the end of the EMU, but we believe the euro zone is in for a banking crisis that will take years to resolve, and an economic depression” said Weinberg in a research note.

“The only option that remains is to strengthen banks so they can withstand the now-imminent shock of sovereign failures.” If he is right, someone is going to have to start thinking about some big bazookas whether Angela Merkel and Germany like it or not.