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Italy Is US Traders' Biggest Problem

Of the three issues facing traders today — earnings, Italy, and the debt ceiling — Italy is the bigger problem.

It is NOT NORMAL for big European banks to be down 5 to 10 percent (ING down 9.6 percent in one day!), particularly on top of 5 percent declines or worst last week. (CounterpointGoldman's O'Neill says S&P hangs on China, not Italy)

What's happening: traders are throwing in the towel on predicting the end of sovereign problems in Europe. (At a glance: Sovereign Credit-Default Swaps)

Why does the U.S. care? Greece, Portugal and Ireland might be manageable...but unhedged exposure is definitely higher for U.S. banks in Italy...plus you will clearly get contagion in the credit markets...markets freeze up.

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As for earnings, for the moment if you're bullish you want to talk earnings, if you're bearish you want to talk Italy. Earnings season news can't be worse than the news out of Europe...

Still, to break out from the April highs we have to put sovereign issue to bed...doesn't look like it will settle soon.

I've been asked, do traders care about the debt ceiling? The answer is, hell yes! Every trader will tell you that Treasury bonds are THE benchmark for gauging financial risk in the current system...if the risk-free instrument has risk then the foundation of the system is broken. Risk would be considered to be massively mispriced...and the world might have to search for another benchmark.

Do you think that worries traders? Sure does. Still, the bond market is not freaking out because traders believe that the outlines of the bare-bone deals are obvious: Republicans will let Bush tax cuts expire for the wealthy, and Democrats will agree to a payroll tax extension and a few other goodies. Everyone declares victory and goes home for the summer. Kick the can? Sure, but it beats even getting close to a default.

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