Italy Bond Market as Euro Proxy

But a calmer market should not be confused with an optimistic one. Investors are still deeply worried about Italy’s mounting political and debt financing woes.

Even the seeming rallying point on Thursday — Italy’s ability to sell out an offering of 5 billion euros in one-year bonds — had a dark side. The interest rate was 6 percent, up from 3.5 percent only a month ago.

In fact, investors and analysts say, the very depth and sophistication of Italy’s 1.9 trillion euro ($2.6 trillion) bond market, the third-largest in the world after the United States and Japan, has made it a proxy of sorts for the euro zone’s deeper problems. Those include the possible exit of Greece from the euro and Germany’s resistance to assuming a larger financial burden in rescuing weaker economies.

Investors have been dumping Italian bonds that they own, and ramping up their negative bets by selling Italian bond futures as well.

The Italian bond market is the only large market in the euro zone outside of Germany to offer investors the ability to buy or sell futures contracts. That has allowed many investors to use Italian futures to place bearish bets on Italy, and as a proxy for the broader euro zone itself.

“The futures market for Italian bonds has become the main conduit now for all investor angst with regard to the euro zone,” said Yra Harris, a trader at Praxis Trading on the Chicago Mercantile Exchange.

In what has become a highly volatile trading environment, investor fears can shift sharply, turning sellers into buyers, especially if it becomes clear that the European Central Bank has started buying bonds. That is why, after Italian 10-year yields touched a dangerously high level of 7.4 percent on Wednesday, word that the bank had started buying the bonds sent yields as low as 6.7 percent on Thursday.

Market jitters were also calmed by indications that Italy was moving closer to appointing a new government with a revamped legislative initiative, making it more likely that the European Central Bank will follow through with additional Italian bond purchases. And further soothing came from the resolution of the Greek political drama, with the appointment of Lucas Papademos, the former vice president of the European Central Bank, as the country’s new prime minister.

Still, European officials are keeping the pressure on Italy. At a news conference Thursday, Olli Rehn, the European Union commissioner for economic and monetary affairs, insisted that Italy’s meeting its fiscal targets and adopting structural reforms was a “sine qua non for restoring confidence in the Italian economy.”

At the root of this confidence drain is the substantial size of debt that Italy must raise from local and foreign investors next year alone: about 350 billion euros. That is about the size of Greece’s total debt.

Over the years, Italy has become a very efficient debt-raising machine, with more than 50 percent of its financing needs met by local banks and investors.

But a substantial amount still must come from foreign investors, which in the past have largely been major European banks. Now these banks are selling their positions to avoid the prospect of having to book losses from their reduced value. And if they are continuing to participate in new bond auctions, as with Thursday’s one-year offering, they are demanding much higher interest rates.

Meanwhile, the negative betting continues. According to officials at Eurex, Europe’s main derivatives exchange, the market for Italian bond futures has increased substantially of late, to as much as one billion euros a day. That is more or less the same size as the market for buying and selling Italian bonds directly.

Many people entering into these futures trades are doing it for hedging purposes or to protect their portfolios if Italy defaults.

But as broader worries about Greece are added to the concern that Italy may no longer be able to finance its debt burden, traders have started to sell Italian bond futures directly — a bet that the euro zone itself might collapse and that Italian bonds will continue to lose value.

Louise Story contributed reporting from New York.

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