Matteo wept for the end of innocence, the darkness of Berlin’s heart, and the fall through the air of a true, wise friend called Piggy.
I don’t want to talk out of both sides of my mouth, so I’m compelled to say it’s a positive development that Italian Deputy PM Matteo Salvini has spent this week walking back his aggressive budget rhetoric.
Up until Monday, Salvini (who found himself in some hot water last month after an ill-advised decision to effectively hold 150 migrants hostage on a coast-guard ship parked in a Sicilian port sparked a kidnapping investigation) has been characteristically combative ahead of a closely-watched budget proposal that’s expected to be a kind of “make or break” moment for the Italian bond market.
The spread between Italian yields and safe haven German bunds blew back out to wides seen during the May turmoil last month, as Salvini continued to insist that “the lords of the spread” were conspiring against Italy’s populists. Here’s what he told Deutsche Welle in an interview published this week:
DW: International markets seem skeptical though. The famous “spread,” that is the risk premium for Italian bonds, has doubled since you came to power. How do you explain that?
MS: There are people who are speculating. There are also people who are against us. Our government is free and independent from the multinationals, from big finance, from banking powers — both international and European. We have no fears. The Italian economy is sound. Italian business is sound. So the economic reforms will provide all the answers that the so-called markets and the “lords of the spread” are waiting for.
As I never tire of reminding folks, his characterization of the BTP-bund spread as a “conspiracy” is absurd for any number of reasons. 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.
Now, the ECB is attempting to normalize policy, which means price discovery will slowly become a thing again. That’s a positive development, because what are markets if not mechanisms for price discovery? Of course it’s not positive for Salvini, because what it means is that in the event his government decides to eschew fiscal discipline in pursuit of a myopic populist agenda, the bond market will punish him by making it more expensive for the country to finance that agenda. If that’s “speculation”, well then long live the “speculators”.
In a hilariously ironic twist, Italy is now reportedly asking the ECB to craft a BTP-specific QE extension designed to shield the country’s bond market in the event the budget causes consternation among investors. Remember, the central bank has been the only net buyer of BTPs for quite a while. Here’s Citi, from a note dated August 31:
Banca d’Italia’s data on BTP ownership, running up to May this year, shows that the ECB became just about the only buyer of BTPs during the peak-QE period. Every other major investor type was a net seller. Crucially, in the initial period where the ECB started scaling back purchases, domestic selling continued and the shortfall was made up by demand from foreign investors. This year, the ECB actually has actually been much smaller than the 12m rolling changes suggest. YTD monthly ECB purchases of BTPs under the APP average only ~ €3.6bn.
That raises this question: What have foreigners been doing lately? As it turns out, the latest BOP data shows capital outflows in May and June of more than €75 billion, according to Citi. “Most of that was from government debt”, Citi writes, adding that “that was a bigger outflow than at any point during the sovereign debt crisis, which was also driven by a foreign exodus – as in 2011-2012.”
Oops. Who knows, maybe Donald Trump can help.
In any event, last weekend Salvini directly contradicted Finance Minister Giovanni Tria when he (Salvini) said this at an event on Sunday:
[We will] try to respect all the hurdles Europe imposes, but the well-being of Italian citizens comes first.
For his part, Tria said he does not intend to breach E.U. limits in the upcoming budget, due by the end of the month. That according to La Stampa, which also said last week that Tria has “asked Salvini and Di Maio to be more prudent with their comments.”
Well now, Salvini is listening. According to comments published by Italian newspaper Il Sole 24 Ore, the Deputy PM says he “won’t do everything immediately” when it comes to implementing the populist agenda. Apparently, lowering the retirement age is something that’s going to get done posthaste, but the flat tax is just “a goal”.
Critically, Salvini said he aims to respect “all” E.U. rules.
Those headlines were good for a rally in BTPs, with December futures rising above the highs seen midway through last month.
For their part, La Stampa says the 2019 budget deficit will come in “around 2%”. That’s better than what Salvini has previously suggested. 10Y yields have come off pretty dramatically from recent highs as the relief rally gathers steam:
Some of this is likely a squeeze. 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.
Goldman weighed in on contagion risk to the rest of Europe earlier this week. “We find most European assets have become more correlated to the BTP -Bund spread but while some re-pricing has happened already, sensitivities remain low and more limited to Italian assets”, the bank wrote, in a note dated Monday, before adding that “FTSE MIB underperformance vs. EURO STOXX 50 has been much more sensitive to BTP spreads in 2018 compared to the sovereign crisis suggesting Italian equity is largely bearing the brunt of the current market turmoil.”
Whatever the case, nobody is out of the woods on this quite yet. Conciliatory rhetoric is nice to the extent it keeps the situation from deteriorating ahead of the actual budget announcement, but it remains to be seen whether Salvini will push the issue in the weeks ahead.
Any further clash between Italy and Brussels on immigration would only add to the tension.