Ciao, Contagion!

You’ve got to think it’s just a matter of time before you start seeing contagion showing up in earnest (especially given recent news out of Spain).

… is something I wrote on Monday.

That was hardly some kind of epiphany and I’m not in the habit (like some folks) of trying to pretend like every obvious observation made in previous posts was somehow evidence of my being a descendant of Nostradamus, but what I guess I would say is that the whole “contagion” story didn’t get enough attention over the past two weeks even as it became clear that the only two options for Italy were i) populist coalition government, ii) new elections.

The former option is market negative on its face and the latter could potentially be even worse because 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, 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.

As BofAML wrote over the weekend, “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.” EUR FRA/OIS spreads are widening out for dates covering September:

(BBG)

And with Italian markets in meltdown mode, contagion is indeed showing up. The euro is now sitting at a 10-month low as political risk collides with a decelerating bloc-wide economy:

2M 25d risk reversals are sitting at their lowest level since prior to the French elections:

(BBG)

Bunds, coming off their best week since 2015, rallied hard, with yields falling to as low as 0.19% at one point. We are nearly back to pre-Sintra levels:

Portugal’s bonds are selling off in sympathy with Italy, as 2Y yields surged 30bps:

Spain, which joined the “triple digit club” last week when it comes to spreads over bunds, is feeling the heat. Bono/Bund spread now at 130bps and counting:

Spanish equities – which had their worst day in 3 months on Friday – are now down more than 6% since the start of last week:

Oh, and the Stoxx 600 Banks index is down some 16% since its late January peaks:

You get the idea. The situation may not be in full-on “spillover” mode (however you want to define that) quite yet, but we have certainly reached the “contagion” stage.

If this continues, it is almost impossible to imagine the ECB moving ahead with hawkish forward guidance on APP next month.