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Analysis: Today’s Italian bond crisis, explained

This morning, my very sophisticated wife asked me, after we woke up, what this Tweet by Bloomberg editor and co-host Joe Weisenthal meant:

“U.S. 10-YEAR YIELD SLIDES 12 BASIS POINTS TO 2.80% ON HAVEN BID.”

Here’s an answer, which is, I hope, of some use to news consumers who find themselves baffled by bonds.

Solman's Sense and Sensibility

All countries run on debt, issuing bonds in their own currency. These are the IOUs they give for the borrowed money. (In the EuroZone, “their own currency” is the Euro.)

The borrowing occurs when an investor buys a bond. When you buy a U.S. savings bond for your kid, for example, the price is the amount the U.S. is borrowing from you.

Bond “yields” or “returns” are the interest rate the borrowing country pays.

Bond “maturities” are how long before the loan has to be paid back: a month, a year, 10 years, and so on.

10-year bonds are a common benchmark to compare one country’s interest rate with another’s.

A few examples, as I’m writing:

U.S.: 2.8 percent
Germany: .31 percent
Italy: 3 percent
Brazil: 11 percent

The variation in a country’s bond interest rate or “yield” depends mainly on two factors:

1: Will there be inflation during the maturity period, so the repayment will be in less valuable money?

2. The threat of default. How likely is it that the country will pay the money back?

Bond interest rates in Italy may seem pretty modest today, about the same as the U.S. So why are folks freaking out? Because Italy’s bond rate has jumped from just 2 percent to 3 percent in no time. That’s a huge move. The Italian government already owes more than 130 percent of its annual economic output. (The U.S., by contrast, owes about 100 percent). Its ongoing cost to keep borrowing money has suddenly gone up by half.

So why are Italian rates rising? Because of inflation? No, Italy can’t print more euros, the currency in which it borrows. Yes, inflation is why Brazil’s 10-year bond is paying 11 percent, and why Turkey’s is paying more than 13 percent. Investors are worried those countries will keep printing more money. But not the EuroZone. Just look at Germany’s 10-year interest rate: less than a third of one percent. So what’s the fear?

The threat of default. Look what happened to Greece. They also borrowed in euros but they simply stopped “servicing their debt,” stopped paying borrowers interest, or the principal when the bonds matured. Given its promises of lower taxes and more public spending on the poor, the new “populist” government in Italy threatens to do more borrowing. And that raises the threat of default.

U.S. 10-YEAR YIELD SLIDES 12 BASIS POINTS TO 2.80% ON HAVEN BID

So what explains the Tweet? Why are U.S. 10-year bond yields going down? (Basis points are 1/100th of a percent.) Because when investors are afraid of holding onto the bonds of other countries they’ve bought, and they start to sell them, where else are they going to put their money? A safer haven like the U.S. And as they buy more U.S. bonds, they are willing to accept a lower return. So interest rates on U.S. bonds are bid down.

Last point, which can be very confusing: because the U.S. bond is more attractive today than it was yesterday, given the alternatives, the price of the bond has gone up. That’s why bond prices go up when yields go down, and vice versa. Since the Italian bond is less attractive, its price is dropping. As I write.

Usually, when bonds pay less in interest, as they are doing today, stocks become more attractive as an investment alternative. So why did U.S. stocks plummet today? Well, despite the 24/7 coverage of the stock market, no one actually knows. But a standard and plausible explanation is that investors are scared of what’s happening to the global economy, at least in the West. Since stocks are shares of big companies, and big companies are only worth as much as they’re able to earn in profits, if the global economy were to shrink, so would the profits, and so, therefore, would the value of company shares.

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