Rare, good news from the euro zone?

GlobalPost

Could the euro zone crisis finally be at a turning point?

The Italian government today auctioned six month treasury bonds, and investors settled for sharply lower interest rates.

European equities markets were somewhat buoyed by the development, rising about 0.5 percent by the end of trading.

So why does this matter?

Well, because it could signal a first, baby step toward relief for the euro zone.

Here's the backstory: In the week before Christmas, the European Central Bank essentially launched a life raft for the continent's debt-swamped banks. The ECB's emergency support enabled banks to borrow at a low, 1 percent interest rate, for three years. Banks gobbled up some 452 billion euros ($590 billion) worth of the cheap ECB lucre.

Officials expect much of that cash to be used to bolster banks' reserves, which are strained by the plummeting value of the bonds they hold. But the hope, in part, is that banks will use a substantial portion of the money to buy the bonds of countries like Italy and Spain, whose borrowing costs have been rising to dangerous heights. In recent months, the Italian government has been forced to pay over 7 percent. At that level, other euro zone countries have required bailouts.

If the banks buy many billions in European sovereign debt, borrowing costs are bound to become more sustainable. (Higher volumes of money chasing bonds drive up their cost, thereby reducing interest rates.) That could be a sweet deal for the financial institutions: by borrowing at 1 percent and lending to euro zone governments at 5 to 7 percent, they stand to reap handsome returns. That is, if they are paid back in full — a very big "if" indeed.

So, the ECB's low-cost, three year loans to banks could help transform the euro zone's vicious cycle — of fear, rising interest rates and slumping economies — into a virtuous cycle — of stronger banks, manageable interest rates for governments, and economic growth.

If it works.

The big question is whether banks will dare take the risk on euro zone governments. Although developed world sovereign debt is usually viewed as relatively safe, nearly two years into the euro zone crisis there are ominous storm clouds on the horizon: the Greek government appears destined to default; Europe's economy is cratering; and Italy will need to raise about half a trillion dollars in 2012 to avoid bankruptcy.

Today's Italian debt auction is a positive sign, but only a small one. So far, Europe's banks appear to be depositing much of their newfound cash back at the ECB, a move that costs them three-quarters of a percentage point in interest (they borrow from the ECB at 1 percent, and the ECB pays them 0.25 percent on their deposits). That means collectively, they're paying more than $10 million a day just to keep their money safe.

They won't want to do that for very long.

Time will tell whether the move will work. Despite the positive auction, Italy's long-term interest rates still hover dangerously near 7 percent.

Rome will auction more bonds later this week. Bankers will no doubt be hoping for more positive news.  

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