[We will] try to respect all the hurdles Europe imposes, but the well-being of Italian citizens comes first.
That’s from Deputy Italian Prime Minister (and man who is under investigation for kidnapping and abuse of office just three months after forming a government) Matteo Salvini, who spoke to supporters (?) at an event on Sunday.
That directly contradicts what Italian Finance Minister Giovanni Tria said last week. According to La Stampa, Tria said he does not intend to breach E.U. limits in the upcoming budget, due by the end of the month. In the same article, La Stampa said Tria has “asked Salvini and Di Maio to be more prudent with their comments.”
Well, count Salvini “not prudent.” His comments Sunday are yet another example of a populist leader causing trouble for no discernible reason. Investors are already on edge about the budget and it isn’t at all clear why he would deliberately undermine his finance chief in public, even if he believes the budget is likely to bump up against the 3% deficit ceiling.
Of course I’m being deliberately obtuse. There is a “discernible reason”. Salvini is attempting to get out ahead of things by painting fiscal profligacy as something that’s necessary for “the people”. That way, when Brussels pushes back on Italy, Salvini can accuse “eurocrats” of trying to undermine Italian sovereignty and impoverish the country’s citizens.
Needless to say, that’s nonsense. If Salvini were actually concerned for the long-term well being of his people, he would try to put the country on a fiscal path that would promote sustainable prosperity rather than chasing short-term gains designed solely to garner support for a populist agenda that will, in the end, be ruinous.
Fitch revised Italy’s outlook to negative from stable on Friday in what amounted to a “wait and see” approach on the budget, but you’re reminded that any downgrade from ratings agencies could turn ugly for BTPs, and fast. The Italian bond market essentially went no-bid in late May and over the past month, the spread over bunds widened back out to levels last seen around that rather unfortunate episode.
On Monday, Goldman is out reminding you that a one notch downgrade wouldn’t “represent an immediate threat to BTPs’ inclusion in bond indices, nor would it immediately threaten BTPs’ eligibility as collateral in ECB operations or for asset purchases.”
While that’s important from a technical standpoint (i.e., Italy can absorb a downgrade without automatically losing eligibility and seeing mechanical rebalancing away from its debt), the psychological impact could be substantial and would likely become self-fulfilling. Here’s Goldman to explain:
If investors expect BTPs to be dropped from the indices, they would likely sell Italian bonds ahead of the rating decisions that would formally trigger such exclusion. As sovereign yields rise and borrowing costs for the Italian government increase, the outlook for Italy’s public debt would deteriorate, making the ratings downgrades more likely. This would validate investors’ concerns about the outlook for Italian debt, leading to a further decline in demand, higher yields and more downgrades. Were ratings agencies to downgrade Italian government bonds, Italian banks would likely be downgraded in parallel. As a result, Italian financial conditions would tighten, the economy slow and (as tax receipts weaken, demands on the treasury increase and the denominator of the public debt ratio weakens) the outlook for public debt would deteriorate. Moreover, investor concerns could also emerge that the ECB would no longer be able to accept BTPs as collateral in its policy operations and/or buy Italian bonds as part of its asset purchase programme (possibly also no longer re-invest the proceeds of maturing BTPs held as part of the ECB’s PSPP portfolio into the Italian sovereign market). Taken together, such outcomes would place an even greater squeeze on the demand for BTPs. At the extreme, Italy could experience a “sudden stop” in the supply of capital, with Italian sovereign markets seizing up.
Essentially then, it’s possible that a one-notch downgrade would be the death knell, given how markets would likely interpret such a move and given investor and trader efforts to get out ahead of whatever comes next.
The bits in that excerpt about ECB reinvestments are key. After QE ends in December, the source of incremental flow will be the reinvestments and if downgrades end up putting the ECB in a position where proceeds from maturing BTPs cannot be funneled back into Italian debt, well then there goes a key pillar of support.
Additionally, Italy reportedly wants the ECB to actually craft a BTP-specific QE extension that would amount to the central bank preventing the market from punishing Italy for beaching E.U. budget constraints. That’s all kinds of absurd, but assuming the central bank could overcome the political hurdles to implementing such a program, rating downgrades could make it a complete non-starter.
As far as how the market is pricing all of this, the charts below suggest folks are short BTPs, or at least according to JPMorgan. The chart in the left pane shows open interest diving in June as everyone unwound longs following the late-May selloff and then being rebuilt to its highest levels of the year. What you see in the right pane is a proxy for net speculative positioning. Basically, JPMorgan multiplies the change in open interest by the sign of futures prices. So, for instance, if prices are falling and there’s a sharp increase in open interest, it likely reflects folks building short positions. This isn’t foolproof, but rather rests on intuition, which in this case is probably a safe bet.
As the bank writes, summarizing, “this position proxy, shown in Chart A43, shows that, while the changes in open interest in late May/early June likely reflected a reduction in long positions, the increase in open interest in August looks more consistent with increases in short positions given they occurred against a backdrop of declining 10y BTP futures prices.”
As far as Italian equities go, JPMorgan notes that while short interest on Italian stocks actually moderated in August even as the BTP-bund spread widened back out, relative short interest (i.e., versus the SX5E) started to move higher again. As far as retail investors go, suffice to say outflows have tapered off, but it doesn’t look like anyone is too excited to jump in ahead of the budget fight:
You can draw your own conclusions here, but it seems increasingly unlikely that Tria is going to prevail upon Salvini to tone down the combative budget rhetoric, especially in light of the open hostility between the deputy PM and Brussels on the immigration issue.
Whether Salvini’s rhetoric finds expression in the budget will be the deciding factor when it comes to determining whether fears about Italy are overblown or justified.