The English language isn’t a sufficient tool to communicate the multiple layers of absurdity and irony inherent in Italy asking the ECB to institute a new round of QE aimed at shielding the Italian bond market from “speculative attacks” by market participants who might be angling to punish the populist government for fiscal profligacy. But who knows, maybe it sounds better in Italian.
Over the past couple of weeks, we’ve lampooned this proposal on multiple occasions. For instance, in “Italy’s Populists Determined To Triumph In Battle With Nefarious ‘Lo Spread’”, we said the following when explaining why the spread between Italian and German borrowing costs has ballooned back out to levels seen during the May 29 BTP crisis:
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.
In other words, Italian bonds are under pressure because that’s what happens when you throw fiscal responsibility out the window. If you’re Italy and you’re determined to flout E.U. budget guidelines and in the process confirm everyone’s fears about what would happen to fiscal policy in the event a populist coalition took power, well then you should expect the bond market to demand a higher premium over safe haven bunds to own your debt. That’s how price discovery works.
Of course price discovery hasn’t worked for years in Europe thanks to the ECB, which has spent trillions attempting to keep “lo spread” and other measures of periphery risk contained. So if there was a “conspiracy” here, it’s been aimed at supporting Italian assets, not undermining them. 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. In fact, the ECB has been the only net buyer of BTPs for quite some time.
“Italy and Spain seem to be more responsive than Germany and France to the central bank’s weekly flows [and] we estimate that the weekly ‘flow effect’ is, on average, close to negative 10bp throughout the QE period in Germany and France, compared with 15-30bp in the large non-core countries”, Goldman wrote earlier this year, documenting how the ongoing central bank bid for sovereign debt puts downward pressure on EGB yields.
“We think that these ECB ‘flow effect’ estimates capture not only the impact of temporary scarcity or potential impairments in liquidity arising in specific market segments as a result of the QE purchases, but also the effect of a stable presence of national central banks in the market, taking the role of marginal buyers should private investors be willing to sell in volatile market phases”, the bank continued, in a note dated April 17.
And that’s just the “flow” effect. That is, that’s just the effect of the ongoing marginal bid and doesn’t take into account the “stock” effect, which captures the benefits of the ECB effectively sequestering assets on its balance sheet, creating what amounts to a permanent scarcity that distorts the supply/demand picture in favor of the assets in question. Here’s a visual on that from the same cited note:
Both of those effects are important when it comes to supporting periphery bond markets. The “flow” effect is likely to be particularly instrumental when it comes to guarding against selloffs during acute times of stress. Here’s Goldman one more time:
Regular and predictable amounts of central bank purchases lower the amount of duration risk dealers are asked to absorb when they underwrite government securities in the primary market. Investors are also afforded a price-inelastic demand curve should they decide to liquidate their bond holdings. This effect is particularly important in countries where sovereign credit risk is higher, and in times of financial stress.
Salvini and Conte and Di Maio undoubtedly understand all of that and they also understand what the consequences are likely to be for Italian debt now that the ECB is prepared to end its asset purchase program in December after a short taper to €15 billion/month starting in September. All indications point to Italy clashing with Brussels over fiscal concerns in the months ahead and the worry is that between the ECB’s reduced support for the market and the investor jitters that will invariably accompany ongoing enmity between the populists in Italy and E.U. officials in Brussels, Italian bonds will come under immense pressure just as the country is attempting to finance an ambitious (and irresponsible) fiscal expansion.
Earlier this week, Salvini, Conte and Di Maio threatened to veto the E.U. budget in retaliation for what they claim is Brussel’s ineffectiveness at helping Italy cope with an influx of migrants.
Now, according to La Stampa, the Italian government is going to reach out to the ECB and ask for an Italy-focused QE program.
“Italy might be relying on the hope of a new round of government-bond purchases by the European Central Bank to shield its public debt from financial speculation and the threats of a rating downgrade”, Bloomberg writes, summarizing La Stampa and adding that according to one official, “the new QE-styled program could have a different name if needed.”
So these officials have literally called up the ECB (or are at least pondering such a call) and asked that the central bank make up a new QE program that will go into effect once asset purchases are completely wound down in December or perhaps even sooner, because once the budget is unveiled next month, you can bet the bond market is going to pounce if Italy thumbs its nose at Brussels.
Once source told La Stampa that the populists are indeed worried about what’s going to happen when new public spending targets are revealed. Here’s a quote from one source:
If the ECB covers you, markets can’t speculate because they don’t make money. And in this way the rating agencies can’t downgrade your debt.
Right. But again, this amounts to the populists in Italy begging the ECB to print euros in the interest of making it impossible for the market to price a budget that Brussels has repeatedly warned Italy will likely cause problems. They are literally flipping Europe the bird with one hand and calling the ECB for what amounts to a preemptive bailout of the bond market with the other.
As alluded to above, this has been in the making for weeks, but this looks like the most definitive reporting on it yet. It also comes on the heels of reports that Donald Trump might be willing to (I guess) use the Exchange Stabilization Fund to buy BTPs next year, a proposition that would be too ridiculous to believe were it not for the fact that the market is already speculating that the President could ask Treasury to use the ESF to sell dollars in the interest of engineering greenback weakness thereby enhancing the effectiveness of the tariffs.