Two Sides of a Very Different Coin – Why bond markets are treating America like it can do no wrong and Italy like a second class citizen

Two economies, the fundamentals of both of which scream ‘panic!’ yet one is borrowing at next to nothing, while the other is being crippled by its debt repayments.

In April 2010, 10-year bond yields (effectively a government’s long term cost of borrowing) were higher in America than in Italy. However Italy’s bond yields rose above 6% this week while America’s stood firm at 3%. It is this high cost of borrowing that is at the root of many of Italy’s problems. Disregarding interest payments, Italy actually runs a budget surplus (known as a primary surplus). If Italy were able to borrow at the same rate as The US, its economic outlook would be closer to Germany’s than to Greece’s as it is at the moment.

These bond yields, looked at it in their simplest, suggests that the market perceives Italy to be much more likely to default on its repayments than America. Is this justified?

Yes: America is still regarded as a safe haven in times of economic turbulence, it provides a more investor friendly environment and, most importantly, is the home of the world’s reserve currency.
No: Both countries have government debt around 100% of GDP and Italy’s primary budget is in a better state than America’s.

The ratings agencies appear to be coming around to the idea that America is not in a great bill of economic health. Moody’s have said this week that there is a 50% chance that it will downgrade US Treasury debt in the next three months. There has been noise coming out of both S&P and Fitch to suggest that they too see a chink in Obama’s armour.

The most likely reason however, that in spite of all this, America is still borrowing at far lower rates than Italy, lies with Italy’s Euro membership.

The US has the freedom, as a last resort, to virtually buy its own debt through quantitative easing. QE3 is considered a very real possibility and would provide the Fed and the American government with some flexibility. Italy does not have this option. The ECB could, theoretically, fulfil this role however it is forbidden to do so by its founding legislation.

The issue of the benefits of Eurozone membership has rolled around once more. Were Italy, Spain or Greece for that matter, operating under monetary independence, with the ability to devalue their currencies and intervene in primary bond markets, would they be better off?