Front and center on everyone’s worry list as the U.S. comes back from the long weekend on Tuesday is obviously Italy.
Italian bonds and stocks (especially banks) were crushed on Monday as investors quickly realized that while the prospect of new elections could conceivably be viewed as more market friendly than the immediate establishment of an outright populist coalition government, the country is now facing months of uncertainty and the timeline seems to suggest that Italians will be going to polls again just as the ECB is set to end APP.
This probably should have occurred to everyone weeks ago. The idea that Five Star and League were going to put together a program and a list of ministers designed to make the transition smooth was far-fetched, and as such, new elections were always in the cards.
As Barclays wrote on Monday, it’s possible that Mattarella’s decision not to back Savona as FinMin (and thus to play spoiler to Five Star and League’s plans) will make things worse in terms of inflaming populist sentiment and exacerbating intransigence.
“Whether L and 5SM decide to join forces ahead of the next election is likely to heavily influence the rhetoric of the electoral campaign and potentially the significance of the next electoral appointment in Italy, and with that, market sentiment,” the bank wrote, adding that “if the two anti-establishment forces were to team up, they might decide to adopt an explicitly anti-European stance, possibly even more forceful than the one held since the electoral campaign started in January.”
BofAML weighed in on the market’s Monday reaction, noting that “new elections — possibly in September — significantly raise the visibility of ‘Italexit’ [and] in those circumstances, any market relief at a further delay in populists coming to power in Italy is likely to be rapidly trumped by deeper concerns over the course of the country, and the monetary union, in the months ahead.”
Right. And given that it’s already almost June and given that the ECB is known to be actively pondering when (i.e. June or July) to start incorporating a sell-by date into their forward guidance around APP, the stage was set for the situation we’re in now, where Draghi has to ponder soaring Italian yields, a blowout in spreads over bunds and widening Italian CDS spreads when making his decision on the future of asset purchases.
The problem here is that the ECB has been the only net buyer of Italian sovereign debt over the past 12 months and there’s a rather precarious setup with Italian credit as well, as 90% of it trades inside of Italian govies. That latter situation is bound to “resolve” itself with Italian credit selling off to close the gap with suddenly risky BTPs, and you’ve got to think it’s just a matter of time before you start seeing contagion to the rest of the periphery showing up in earnest (especially given recent news out of Spain). And then there’s the old sovereign-bank doom loop which can be neatly visualized as follows:
With all of that in mind, consider this from the same BofAML note cited above:
The Italian press this morning was widely mentioning 9 September as the likeliest date for the next elections. This means that any stable Italian government would not take office before the ECB has started its short taper, in our view (we think the central bank will gradually wind down its net purchases between October and December). In our baseline so far, tension with the Europeans would have gradually risen through the summer to peak in September with the draft budget bill for 2019, but crucially the central bank would have still been there as support. If a populist agenda were to be comforted in September, and possibly made more radical during the campaign, no central bank help will be available to soften the market reaction. We continue to think that the political developments make it more difficult, not easier, for the ECB to prolong QE into 2019. Extraordinary monetary support was predicated on an implicit contract with governments on fiscal prudence and structural reform. This is missing in Italy at the moment.
As I wrote in a piece out earlier on Monday, this is a lose-lose scenario for the ECB. If you let it spiral out of control by removing the QE bid (and thus effectively telling the rest of the market that any purchases of Italian debt are not underwritten by the central bank), then we’re right back to 2011. If you extend QE to accommodate the populist push, well then you open the door to accusations (from Berlin) that Draghi is engaged in financing an irresponsible, anti-EU government.
Our buddy Kevin Muir (of Macro Tourist fame) was out reminding folks that the recent widening in the BTP-bund spread is a blip on the proverbial radar screen in the grand scheme of things (i.e., compared to the eurozone debt crisis):
And while it’s always good to keep perspective, Robin Brooks (who, as some of you are probably aware, is now Managing Director and Chief Economist at the IIF after departing Goldman) suggests comparisons with the debt crisis might be a bit of a misnomer.
“The bond market sell-off on the Euro periphery is striking for its severity,” he wrote on Twitter, adding that “the GDP-weighted spread of 10-year periphery sovereign bonds is still a long way below 2011/2 levels, but it’s also fair to say that the speed of this sell-off makes that point somewhat academic.”
The question now is what happens if the ECB pulls back.
“Given rising uncertainty, can the ECB end QE as anticipated?,” Brooks asks, before implicitly answering his own question by noting that “QE purchases (blue) allowed others to rotate out of periphery sovereign bonds, notably non-residents of the Euro zone (red).”
Again, if the ECB isn’t buying, it’s left to price sensitive investors to provide the bid and who the hell is going to be willing to lend money to Italy given the current political backdrop at anywhere near current yields? Remember, until four weeks ago, “investors” (scare quotes there for a reason) were still willing to pay the Italian government for the “privilege” of lending it money for two years despite the fact that there literally was no government. What happens to that scenario if the ECB isn’t effectively guaranteeing those bonds?
Price discovery has been murdered in Europe (see: “Italy’s Populists Furious That Bond Spreads Are Trying To ‘Blackmail’ Them, But The Real Victim Here Is Price Discovery” for more on that). If the ECB exits, the market will have to find a clearing price that’s some semblance of honest and I don’t know about you, but I wouldn’t want to lock up my money with Salvini for a decade at just 230bps over bunds.
The above-mentioned Robin Brooks concludes as follows:
The severity of this sell-off is worrying.
Yes. Yes, it is.