You know if I didn’t know any better, I’d be inclined to say that Wednesday’s upbeat economic data out of Germany was “bad” news for anyone who’s still long European risk.
The combination of decelerating eurozone economic activity in Q1 and political turmoil in Italy seems likely to give the ECB pause when it comes to winding down QE in September, especially considering the potential for new Italian elections to morph into a de facto referendum on the euro.
The Governing Council has been at pains to paint a lackluster Q1 with the “transitory” brush because you know, what else are they going to do? If you acknowledge that the economy may have peaked and then you stick to the normalization push, well then you run the risk of “quantitative failure” and if the April iteration of BofAML’s European credit investor survey is any indication, market participants are acutely aware of that risk.
Decelerating growth is in no small part responsible for recent euro weakness although the turmoil in Italy has effectively negated that FX tailwind when it comes to European stocks. Expectations that APP will run beyond September should be euro bearish which in turn is bullish for regional equities and for € risk more generally, right up until people start to get the idea that the Italian “problem” could be systemic. When it comes to the “systemic” characterization, one great way to visualize it is to plot the ISDA basis with iTraxx SubFin:
So the issue here is that when you get a raft of upbeat data from the bloc’s most important economy (Germany), it helps validate the ECB’s contention that the Q1 weakness was indeed merely a bump in the road.
That, in turn, helps bolster the case for policy normalization and ostensibly reduces the chances that Draghi will be inclined to eschew a hard stop on APP in September in the interest of propping up Italian bonds. Here’s Bloomberg summing up the data out of Germany:
Inflation in Europe’s largest economy jumped to 2.2 percent in May, exceeding the rate the European Central Bank aims to achieve for the entire region. Unemployment fell to a record low of 5.2 percent, economic sentiment improved after three consecutive declines and retail sales rose for the first time since November.
That right there is largely responsible for the euro rally on Wednesday:
If the data turns around, it will mean Draghi loses some of the cover he might have had when it comes to bailing out Italian assets.
As long as the bloc’s economy is decelerating and the inflation data is subdued, he can justify a dovish shift by citing the data, effectively allowing him to dodge accusations of letting Italian politics dictate the normalization path.
If, however, the econ turns around, there’s no cover and the ECB will likely push ahead irrespective of what happens in Italy – up to and until the situation there morphs into something that represents an acute systemic risk.
While the speed of the selloff in Italian bonds was indeed unnerving on Monday and Tuesday, the fact that auctions went reasonably well on Wednesday (and there are a number of caveats on that which you can read here) and the fact that 10Y Italian yields at ~3% hardly represents a complete loss of market access, likely means good news on the economic front will trump bad news out of Rome when it comes to the ECB’s propensity to slam the brakes on the normalization push.
On that note, I’ll just leave you with something I said a week ago before things really got messy in Italy:
Call me crazy, but if I were long risk assets, I would almost hope the situation in Italy gets at least a little bit worse. I don’t know what the exact tipping point would be, but it would be hilarious if, after hitting whatever the nominal level on 10Y Italian bond yields and/or the BTP-bund spread is that effectively forces Draghi to rethink ending APP in September, global risk assets rallied knowing that the ECB was forced to extend QE.
