Italy’s Populists Determined To Triumph In Battle With Nefarious ‘Lo Spread’

Listen, League leader and proud xenophobe Matteo Salvini is no fan of “lo spread”, ok? 

“Lo spread,” is the somewhat derisive term Italians use to refer to the BTP-Bund yield differential, which Salvini likes to imagine is an actual living, breathing, animate thing that is capable of conspiring against Italy’s populists.

As absurd as that characterization is, he’s not entirely wrong. After all, investor psychology helps dictate “lo spread” and investors are people capable of having a sense of purpose. Sometimes, that “purpose” is speculation aimed at kicking vulnerable assets while they’re down.

But as I was at pains to explain to Salvini back in May, the ECB has spent trillions attempting to keep “lo spread” and other measures of periphery risk contained over the past several years. So if there is a “conspiracy” here, it’s aimed at supporting Italian assets, not undermining them. In other words, the market has been hamstrung in its capacity to punish fiscal profligacy in the periphery post-2012 because “whatever it takes” and Europe’s subsequent plunge down the QE rabbit hole effectively relegated real price discovery to the dustbin of history.

Of course you can point to month-to-month fluctuations in capital key deviations by the ECB and try to posit conspiracy theories if you want. I’ll give you an example.

The BTP market melted down on May 29 after the Five Star-League coalition’s effort to form a government behind Giuseppe Conte briefly collapsed. Long story short, President Mattarella wasn’t enamored with the idea of euro-skeptic Paolo Savona being finance minister. Two days later, liquidity evaporated in the Italian bond market and things started to unravel in spectacular fashion as 2-year yields spiked the most on record.

A few weeks later, some folks posited that Draghi was trying to send some kind of message to the new government in Italy by deviating from the capital key in favor of Germany in May. When you think about that theory, you do want to note that there were technical considerations at play. Here’s what BNP said at the time:

The key focus in May’s data fell on deviations versus the capital key, with Germany’s monthly net purchases coming in 5.3% above the capital key, the highest reading since the start of QE. Meanwhile, monthly net purchases in Italy and France came in 1.5% and 1.7%, respectively, below the capital key, ending months of deviation above the capital key (Chart 3). The absolute changes in monthly net purchases were revealing and suggested that the aforementioned dislocations versus the capital key were likely caused by some of April’s PSPP reinvestments in Germany being carried over to May. The monthly net purchase amounted to EUR 6.9bn in Germany, much higher than the EUR 4.8bn/month average in January-April this year. Meanwhile, in Italy and France the monthly net purchases amounted to EUR 3.6bn and EUR 4.2bn, respectively, broadly in line with the average EUR 3.6bn/month and EUR 4.1bn/month so far this year. Marginally slower monthly net purchase in Italy versus April (EUR 3.6bn in May versus EUR 3.97bn in April) could have been due to liquidity conditions.

In any event, the point is that Salvini likes to suggest that European officials are using financial markets to blackmail Italy and effectively undermine the democratic process by deliberately pushing Italian assets lower to “punish” voters for choosing a populist government. In reality, what you’re seeing in Italian bonds is simply a reflection of what happens when the ECB is set to have less of a presence in the market and price sensitive investors begin to ponder how serious Italy is (or, more appropriately, isn’t) when it comes to sticking to E.U. budget guidelines.

Turkey’s trials and tribulations serve as a stark reminder of what happens when populist tendencies triumph over economic reality when it comes to fiscal policy. That’s part of the reason why the euro is under siege amid the lira collapse (that, and the exposure of European banks).

Last week, reports indicated that Italy has contacted the ECB to discuss what the populists are characterizing as “speculative” attacks on the country’s debt. In short, “lo spread” has blown back out to its widest levels since the May debacle.

(Bloomberg)

Again, there is no “conspiracy” here. This is down to investor concerns about the budget due next month and worries that with the ECB set to wind down asset purchases at year end, price discovery will reassert itself and Italian bonds will reflect the reality of the country’s fiscal situation. The turmoil in Turkey comes at an inopportune time because, as noted above, it reminds investors what can happen when the government is fiscally irresponsible.

“Should the Five Star Movement-League coalition break the bloc’s deficit limit of 3 percent of gross domestic product, the premium to hold Italy’s debt over Germany’s could blow out to 470 basis points — a level not seen since the euro-area debt crisis’, Bloomberg writes, in a piece out Monday, adding that according to a survey they conducted, “if the government plays ball in the September budget, it may be rewarded with the same or even lower borrowing costs than at present.”

And see, that’s how it should be. The market should be allowed to price risk appropriately and a government that thumbs its nose at E.U. budget rules will have to pay the cost for that belligerence if it wants to borrow. That’s not “speculation” by the market. That’s just called “price discovery” and in the pre-QE world, that’s what markets did – they served as a mechanism for price discovery.

But don’t tell that to Matteo Salvini. “We will resist the bond yield spread, speculation, credit downgrades, attacks, disputes,” he told reporters on a live SkyTG24 television broadcast Monday, adding that he’s going to “go forward calmly”.

For his part, E.U. economy chief Pierre Moscovici tried to be nice in an interview with Bloomberg TV, calling Italy “a strong country”. Asked whether he expects a fight with Salvini, Moscovici said this:

I hope not. I think that would not be fruitful for anybody. I’m not frightened about Italy, but I’m prepared to have very solid discussions with the Italian government on the next budget. There must not be and there cannot be confrontation between Italy and Europe. That would be silly.

Yes, that would “be silly”. But Salvini is a silly guy, so plan accordingly.

Don’t let the hilarious irony be lost on you when you read commentary about this situation penned by populist-leaning financial websites. For years, some of those sites decried the destruction of price discovery at the hands of central banks, but the very second price discovery reasserted itself in Italian debt, those same sites cried foul and insisted that the ECB should step in to support the market. More to the point, they insisted the ECB should subsidize the populist government in Italy. What happened to wanting honest price discovery free from the influence of ECB purchases? I guess it’s fine for central banks to commandeer markets as long as that means helping populists paper over poor fiscal discipline.

In the same vein, read this quote from an interview with Claudio Borghi, the euroskeptic head of the budget committee in Italy’s lower house:

There cannot be a system at the mercy of market movements without any shields by the central bank. Nowadays there is a system that has a residual amount of quantitative easing, but with everybody knowing that this is being phased out and will come to an end soon.

Right, Claudio. Which means the market gets to decide how much you pay to borrow. And that means you can’t just do whatever you want when it comes to the budget. Or actually, you can, but if you go down the road to fiscal insanity, then you will pay the cost in the bond market. That’s how markets work.

To be fair, though, it’s certainly possible that the ECB will pull its support of the BTP market (where the central bank has been essentially the only net buyer) while tamping down credit risk in the rest of the periphery to send a message. In other words, my sarcasm and extreme disdain for Salvini aside, Matteo isn’t completely wrong here.

For instance, have a look at these charts from Goldman:

(Goldman)

“Although the impact [of rising Italian yields] on peripheral markets has been limited relative to previous episodes, the impact on the Bund has been sizeable, and is — in standard deviation terms — comparable to previous periods of sovereign market stress”, the bank writes, in a note dated August 17, adding that “around 10-15bp of the 30bp drop in Bund yields since mid-May can be attributed to Italy.”

But while the spillover to bunds is demonstrable, there’s been almost nothing in the way of spillover to “European systemic risk”, where Goldman’s proxy is heavily influenced by co-movement in other peripheral spreads.

What accounts for that juxtaposition? Well, here’s Goldman’s answer:

These price moves could simply be a re-weighting of portfolios from BTPs towards the Bund, the only reliable safe asset in the Euro area. But the relative calm in other EMU sovereign markets is not quite consistent with crisis levels of flight-to-safety pressure on the Bund. An alternative possibility is that what is keeping peripheral markets (ex-Italy) relatively calm is the same mechanism that is pulling down core yields — the ECB. If we assume that the market has internalized the message from ECB President Draghi’s 2012 “whatever it takes” speech, then current market moves imply that investors have confidence that the ECB will shield other EMU markets from contagion — at least for the current degree of BTP-bund spread widening. In theory, the ECB could allow markets to price additional credit risk in the Italian curve, while acting to prevent ‘unwarranted’ spillovers into other markets. Related to this, markets may also be pricing a higher probability of ratings downgrades that could affect Italy’s eligibility for ECB purchase programmes.

Again, Salvini isn’t totally wrong to couch things in conspiratorial terms, but he is mostly wrong. The cold, hard reality of this situation is that Italy’s new government needs to act in a way that’s some semblance of fiscally responsible or risk paying the piper (figuratively and literally) in the bond market.

As Trump would say, “we’ll see what happens.”