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Market participants braced for the worst ahead of the most recent Italian debt auction. Can you blame them? Bond yields spiked just the day before, suggesting that the government may have a hard time finding buyers for its medium and long-term debt.

But to everyone’s surprise, the auction turned out to be a success! Italy sold the maximum 6.5 billion EUR bonds. However, you should know that it came at a price – higher bond yields.

Borrowing costs for 4 billion EUR worth of 10-year bonds was up at 4.83% from 4.17% last month. Rates on 2.5 billion EUR of 5-year bonds also rose to 3.59% from 2.49% in January.

If you’re a cool cat and you’ve gone through the School of Pipsology, you probably know that higher bond yields reflect investor concern. Remember that the bonds issued yesterday are essentially IOUs from Italy. Owning a bond basically means that the government borrowed money from you.

Of course, when investors feel that there’s a risk that the borrower may not be able to pay them on time (or at all), they demand higher returns.

By now we know that the root of this renewed concern for Italy lies in the inconclusive results of the Italian elections. As I mentioned the other day, Italy now faces the very real risk of a hung parliamentary.

However, I think one of the main reasons the markets have been so worried is because of the support that Silvio Berlusconi and Beppe Grillo have been seeing.

We’re already quite familiar with ex-Prime Minister Berlusconi’s ill reputation. After all, he’s been the topic of countless headlines, but mostly for the wrong reasons (i.e. throwing “bunga-bunga” parties and allegations of corruption). Needless to say, he doesn’t exactly inspire confidence in investors.

Meanwhile, a victory for comedian Beppe Grillo’s party, which is anti-establishment and anti-austerity, threatens to undo some of the progress Mario Monti made in implementing budget cuts. Without these austerity measures (which Berlusconi also opposes), the euro zone risks another debt crisis. And to think that the region has finally been showing signs of improvements!

Markets relieved

From the looks of it, the markets seem to be relieved that the auction didn’t turn out to be a bust. European stock markets chipped away at Tuesday’s losses, while the euro made headway against the dollar to push EUR/USD above 1.3100.

EUR/USD 15-minute Chart

I suppose what we should take away from the Italian bond auction is that Italian political situation hasn’t completely spooked away investors. But on the flipside, the rise in yields indicates that the markets do recognize the heightened risk in the region.

Overall, it’s hard seeing the euro making sustainable headway up the charts until this whole situation is resolved and we find out what kind of government will be leading Italy.