Italy Could Keep Shaking Things Up

The swirl around Italy's debt woes is likely to dominate markets Thursday, after the rapid rise in Italian borrowing costs sent risk assets cascading around the globe Wednesday.

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There are a few U.S. economic reports expected but nothing is likely to steal attention from the bubbling troubles in Europe that are sending warning signs through international financial markets. Weekly jobless claims are reported at 8:30 a.m. EST, as are international trade data and import prices. The Treasury auctions $16 billion in 30-year bonds at 1 p.m., an auction traders are watching closely after Wednesday's relatively cool reception for $24 billion 10-year notes.

Japan stocks were sharply lower in early Thursday trading, after Wall Street and European stock markets tumbled Wednesday. U.S. Treasurys and the dollar gained as investors sought safe havens. U.S. stock futures were slightly lower in evening trading.

Investors were initially cheered Tuesday by Prime Minister Silvio Berlusconi's promise to step down after a 2012 budget is approved. But the lack of movement Wednesday and his call for an election was a concern, as Italian interest rates continued to rise.

Italy's 10-year bond yield rose above 7 percent for the first time Wednesday to finish at 7.25. Seven percent is a red flag for markets that see it as unsustainable, and it is also the same level that led Ireland, Greece and Portugal to seek bailouts.

Italy, however, is different than those other countries. It is the world's third largest debtor nation, after the U.S. and Japan and has $2.6 trillion in debt. But some analysts also say that Italy's economy is far stronger than that of Greece, and it has more flexibility, if it changes course. Last week, Berlusconi agreed to allow the IMF to monitor its financial reforms.

Rumors circulated Wednesday that the ECB was holding an emergency meeting on Italy, but the ECB declined to comment. Traders speculated the ECB was a big buyer of Italian bonds Wednesday.

Italian President Giorgio Napolitano Wednesday promised Berlusconi would be stepping down soon. According to wire reports, the Italian Senate is expected to give final approval Friday to a package of measures that would help rein in debt and stimulate the economy, while the House is expected to do the same Saturday, making way for Berlusconi's exit on the weekend.

Napolitano named Mario Monti as a "senator for life" with voting privileges in the upper house. Monti is the respected former European Union competition commissioner, who derailed GE's plans to buy Honeywell.

There was speculation he might be tapped to head an emergency government. "I'm guessing the business community in Italy must be alarmed at what's going on. The question is how much of a voice do they have as a group. .. I don't think this is going to take months. I think it could happen very quickly. The problem is if the opposition says they want an election," said Amitabh Arora, Citigroup head of asset allocation research.

Arora said the markets would not be satisfied with the promise of an election. "It's not clear a government formed in a new election would be any better. I think it almost has to be adult supervision," he said. Arora said he expects risk assets to continue to stay under pressure.

He notes that the Italian 10-year was at 5.95 percent when the European bailout plan was announced last month, and has quickly moved above 7 percent. "The other risk assets are merely catching up with how bad the European sovereign situation is," he said. Greece's efforts to form a new government unraveled Wednesday, spooking markets in afternoon trading and sending the Dow down more than 400 points for a time.

The Dow finished the day down 389 at 11,780, and the S&P 500 was off 46 points at 1229, just below an important level of support at 1230. Greek President Carolos Papoulias plans another meeting with political leaders Thursday morning.

"I think the markets recognize we haven't resolved this first one in the last 18 months, and we're still not there...What happens with the real big one. The one that has been there in the background all along," CRT Capital chief Treasury strategist David Ader said, of Italy.

Arora said one thing that could turn the focus from Europe is if the U.S. bipartisan Super Committee looks to be successful at finding $1.2 trillion in deficit reductions. He said Citigroup recently surveyed market participants and about half of them think the committee will fail.

But Citi political analysts, due to shifting political currents, think the Congressional committee has a good chance of succeeding in time for its Nov. 23 deadline, he said. "It would be a burst of good news," he said.

Traders will also be talking, no doubt, about the performance of candidates during the Republican presidential debate on CNBC Wednesday night, as they look for a frontrunner.

Investors will also be watching the municipal bond market for reaction to the bankruptcy filing by Jefferson County, Ala., the biggest municipal bankruptcy ever.

"The market's going to care," said Ader. Jefferson County's problemsstarted when it refinanced its sewer system with interest and auction rate bond deals. "Contextually, there's been a lot of discounting of this sort of event. Still, the high yield municipal space comes under additional scrutiny," he said.

What Else to Watch

Fed Chairman Ben Bernanke holds a town hall at Fort Bliss in Texas with soldiers and their families. His comments will be closely monitored, given the situation in financial markets. Bernanke has said the Fed would consider a new round of quantitative easing if needed. Several strategists said Wednesday should the market turmoil continue, it could push the Fed closer to QE.

It has been expected that another round of asset purchases would focus on mortgage securities instead of Treasury securities, as in the Fed's "QE2" program which ended in June.

Treasury Secretary Tim Geithner attends the Asian-Pacific Economic Cooperation finance ministers meeting in Hawaii Thursday. Atlanta Fed President Dennis Lockhart speaks at 9 a.m. at the Fed's small business conference in Washington.

Cisco's better-than-expected earnings news may have some impact on technology shares Thursday. Cisco shares were up nearly 3 percent in after hours trading. Companies reporting earnings before the opening bell include Kohl's, Siemens , and Viacom . Disney and Nordstrom report after the close.

Follow Patti Domm on Twitter: @pattidomm