Italy! Italy! Italy!

The euro zone periphery was a sideshow. This stuff with Italy is the real deal. With yields at 6.7% and rising, it’s game over for the euro zone. The extend and pretend stuff ain’t gonna work.

And if you are an investor, this is the moment of truth. Everything – every asset class – depends on how the euro zone performs in the Italian Job. There are only two outcomes, here. If Italy blows up, a Depression is upon us; banks would be insolvent, CDS triggers would implode the system, bank runs would begin, stock markets would crash, and you will would see sovereign debt yields go to unbelievable lows for nations with a lender of last resort. If Italy survives, I would expect a monster rally in periphery debt, stock markets, and bank shares and a selloff in CDS at the minimum. However, the euro zone is already in recession so that rally will not be sustained.

Forget about Berlusconi and austerity in Italy. That’s a sideshow too. Austerity is not going to bring Italian yields back down. These days are over, folks.

Here’s the real problem: Italy needs to run a primary budget surplus (excluding interest payments) of about 5 percent of GDP, merely to keep its debt ratio constant at present yields. That’s never going to happen. So the yields for Italian bonds must come down or Italy is insolvent. More than that, a stressed Italy means a stressed euro zone and a deepening recession with all of the attendant ills that means: Ireland would suddenly start missing deficit targets for example. Bank shares would be under stress, triggering more Dexia’s. So even if Italy limps along at 7 percent yields, we will see a nasty double dip recession and bank failures. And we know that yields will rise. Last November, we were discussing Ireland in the same way with its yields at these levels. Soon, the yield went to 9% and Ireland was forced into a bailout – one that Italy is to big to give.

So we are definitely facing a real financial Armageddon scenario here. That’s why questioning Italy’s solvency leads inevitably to monetisation. I’m not the only guy who knows what would happen. Policy makers know that Italy owes German banks 116 Billion euros.  They know that Italy is too big to fail and they will respond. But, policy makers are faced with a simple either or here. Small bond purchases won’t do. We see that already because Italy’s yields are well above 6% for 2-year debt. Credible lenders of last resort use price, not quantity signals. For the ECB, it’s not about buying up Italian debt. It’s about credibly defending Italian government bonds as the monopoly supplier of reserves with a specific target price. Central banks are price-targeting monopolists. They can only be effective if they realise this affects everything they do. The role of the lender of last resort is about price, not quantity.

I expect the ECB to cave and target a maximum yield or a maximum spread to Bunds for Italy. Until they do, things will only get worse. In fact, they can get just bad enough to start bank runs and a severe global double dip recession. And I expect the ECB to dither. The cognitive dissonance is too large. Unless the ECB stops dithering soon, we could see a depression even before the Italian Job goes into action. All of the risk now is to the downside in my view. The number of upside scenarios are limited by how quickly the ECB can do an about face – and that’s not going to be quick.

Investors should shun risk and take out whiplash insurance via out of the money calls because there are only two options on this one. One is a Depression, the other is a delayed ECB response preceded by turmoil, followed by a brief euphoria and then double dip.

P.S – remember, my motto is hope for the best, prepare for the worst and expect something in between. I like to be optimistic. So if I am telling you point blank that a European double dip is the absolute best you can hope for, you know there are a lot of worse outcomes.

This post originally appeared at Credit Writedowns and is reproduced with permission.