U.S. and Italy: Dancing To Different Beats

At a first glance, it would appear that the U.S. and Italy economic situations are quite similar. For one, both nations have taken the spotlight recently thanks to some dance offs between politicians.

Over in Washington, Congress has yet to come up with a solution to their debt ceiling, which is set to expire next month. Meanwhile, Italy has its own problems as Italian Economic Minister Giulio Tremonti and Prime Minister Silvio Berlusconi have been at odds, thanks to the passing of a 48 billion EUR austerity package.

Both these events have got ratings agencies tingling, as it raises that the chance that either country may eventually default! Moody’s has made threats that they will downgrade the U.S.’ debt rating if lawmakers don’t raise the debt ceiling and end up missing interest payments. And seeing as how rating agencies have downgraded Greece, Ireland, and Portugal in recent weeks, there’s no doubt in my mind that Italy could be their next target.

With how large their debt-to-GDP ratios are, it’s no wonder that ratings agencies are just waiting for that chance to slap a downgrade on the U.S. or Italy. The IMF estimates that Italian debt will stand at a massive 120% of GDP by the end of the year, just second behind Greece in the euro zone. The U.S. ain’t so far behind, with the IMF predicting a debt-to-GDP ratio of 100%

But that’s where the similarities end. Looking at the bigger picture, the two nations situations couldn’t be more different.

If you pay any attention to bond auctions, you’d notice how different the markets perceive the two countries. While the U.S. is able to issue 5-year bonds with yields at 1.48%, Italian bonds of similar maturity recently went for 4.93%.

This indicates international markets are more willing to put their moolah in American bonds, even though the economic outlook ain’t exactly better than Italy’s. This allows the U.S. pays much less in interest payments than Italy.

How big of an effect would the difference have? Well, to put this into perspective, if Uncle Sam was borrowing at similar rates to Italy, its budget deficit would grow by 50% to $2.4 TRILLION! Hot dang!

There are two main reasons for this.

First, the U.S. has its own central bank, the Fed, to come in and flood the market with cash (via bond purchases) if they need it to. Unfortunately for Italy, the ECB isn’t as free rolling and wouldn’t be nearly as willing to buy up Italian bonds. Private investors have to step in, but to entice them to pick up Italian bonds, Italy must offer higher yields.

Secondly, the U.S. has the benefit of being the world’s reserve currency. At the end of the day, people still want and need dollars. With all the problems that the euro zone is encountering right now, there are some concerns as to how much longer the bloc can stay together.

Now, the big question for all you forex traders is what effect could this have on EUR/USD?

EUR/USD Daily Chart

Over the past couple of weeks, we’ve seen some topsy-turvy moves on EUR/USD. First, the euro tanked thanks to concerns about Italy and downgrades on other euro zone countries. Then, before you could say “cha-cha”, it was the dollar’s turn to slump down the charts, as the Fed said it was open to the possibility of QE3! News that U.S. debt could get downgraded if U.S. lawmakers don’t solve the debt ceiling issue didn’t help the dollar’s cause either.

Looking forward, it’ll be interesting to see whose two left feet will causes it stumble first. As long as contagion fears and debt downgrades plague the euro zone, I don’t see EUR/USD setting of for any new highs above 1.4500. At the same time, if the Fed does decide on QE3 or if U.S. Congress continue to butt heads on the debt ceiling, we could see the dollar weaken, which could keep EUR/USD above the previous swing low at 1.3500.

I know many of you love trading EUR/USD, so make sure you stay on top of the markets so you don’t get miss a step and get floored by the markets!