Last week saw contagion fears rise sharply in the Eurozone as Italy emerged at center stage of the European debt drama.
The euro itself tumbled against the U.S. dollar while Italian and Spanish bond yields rose.
Bank stocks, especially Italian banks like Intesa Saopaolo (ISNPY, quote) and Unicredit (UNCFF, quote), gyrated wildly.
The fear in the market briefly sent Italian and Spanish 10-year bond yields to more than 6%, a level last seen in 1997. It also pushed the spread between Italian and ultra-safe German bonds to more than 300 basis points, a first since the inception of the euro.
The Italian 10-year bond did finish the week at a lower 5.76% yield as China was a rumored buyer, still the highest close in more than a decade.
Each 100 basis-point rise in bond yields raises Italy’s cost of financing by 3.2 billion euros this year and more than 6 billion in 2012.
The contagion spreading to Italy is particularly worrisome because of the sheer size of its bond market, one of the largest in the world. Italy has 1.6 trillion euros of outstanding debt in bills and bonds — a market larger than what other European countries are likely to refinance in the event of a default.
As for Unicredit and Intesa Saopaolo, the problem is simple: the Italian banks hold much more Italian debt as a percentage of their fixed-income holdings.
Many believe European bond markets are nearing a key inflection point. Even France is seeing increasing volatility in its debt market.
The key point seems to be the 7% level. Many say that if Italian and Spanish 10-year bond yields exceed that level, it will be a point of no return — where bailing out these countries will no longer be feasible.
The clock is ticking on European policymakers to come up with a plan to “save” Italy and Spain as rates in Italy climbed to 6% again and even higher in Spain.
Investors in the iShares MSCI Italy Index ETF (EWI, quote):
and the iShares MSCI Spain Index ETF (EWP, quote) need to keep an eye out for what actions these policymakers take if any.