It’s not terribly surprising that the market is aghast at the utter lack of regard for decorum Italy’s populist leaders demonstrated on Thursday when they announced their budget deficit target.
What is a bit surprising though, is just how hard Italian assets were hit on Friday considering this really wasn’t difficult to see coming.
The decision by League leader Matteo Salvini and Five Star chief Luigi Di Maio to thumb their noses at Brussels and ignore Finance Minister Giovanni Tria’s pleas for fiscal restraint was entirely predictable.
As we noted on Thursday, the appeal of populism lies in the promise of short-term fixes for complex problems and in Italy (as in the U.S.) delivering on that promise entails reckless fiscal policy.” In other words, what else was Di Maio going to do? Was it realistic to expect Salvini would suddenly, out of the blue, decide to respect Brussels’ wishes? Did anyone really think Tria had a handle on this situation?
The answer is “Of course not” to all of three of those questions.
At best, you could argue that if Di Maio and Salvini were going to take a stand on this, they should have made that clear weeks ago as opposed to digging in their heels at the last minute. But even there, both men have for months played a kind of good cop-bad cop game with themselves, where one day they’re committed to respecting budget rules and the next day they’re railing against the tyranny of nefarious eurocrats.
Consider this from from former trader turned Bloomberg columnist Richard Breslow, out Friday morning:
I understand that surprises happen. And hindsight isn’t fair to club someone over the head with. But sometimes it is. Just yesterday demand at the 10-year BTP auction was the highest since last May. Unfortunately for those awarded an allocation, yields today are a whole lot higher. To say the least. That was putting an inexplicable amount of faith that the finance minister had his two deputy premiers well under control. On very little evidence. Other than a wishful assumption that the even hard-line populists always bow to market-friendly necessities. We really have lost our way.
Richard is more generous than I am. I club people over the head with hindsight all the time, and because I also do it to myself, I feel like I’m completely justified.
In any event, the reaction in Italian assets is extremely violent, as though this news were somehow completely unexpected. Italian banks, for instance, are having their worst day since Brexit, off a truly harrowing 8%:
UniCredit, BPER Banca, Banco BPM, UBI and Intesa are an absolute mess and literally all of them were halted at one point.
More broadly, Friday is shaping up to be the worst day for the MIB since U.K. voters, in the thrall of a populist delirium of their own, voted to leave the E.U.
The reaction in BTPs feels a bit little less severe, especially in the context of the late May meltdown, but it’s anything but pretty. 10Y yields are up 34bps, for instance:
We’re back to the worst levels of the year there:
December futures tumbled:
Here’s “lo spread” (which Salvini is probably scoffing at on Friday):
The front end is rough, although again, things aren’t nearly as acute as they were during the late May fiasco when the market was basically no-bid. 2-year yields are up some 40bps on the day:
Here’s some context:
All of this might seem overblown, but is it really? After all, Tria’s credibility is obviously shot. “Having a lame duck finance minister in this situation will require a higher premium,” Commerzbank’s Christoph Rieger said Friday.
“This is a defeat for Mr Tria, as a guarantor of fiscal prudence, and a victory for the more aggressive line pursued by the coalition parties, the Five Star Movement and the League”, BNP wrote Thursday, in a flash note following the announcement of the new deficit target.
“We see the risk that Italy could lose further political capital in the eyes of financial markets and European partners”, Barclays warned today, adding that “this will make it difficult for the current coalition government to keep investor confidence as even Finance Minister Tria, who was probably considered an anchor to fiscal discipline, may be perceived as unable to counteract the government’s loosening fiscal stance.”
We’ve said it before and we’ll say it again: Thanks populism!
For now, we’ll leave you with a quick rundown of what might lie ahead from the same Barclays note cited above…
We expect Italy will enter a prolonged period of volatility. In particular, we identify potential sources of volatility that are likely to impact Italy in the near and medium term.
- Potential difficult institutional relationship with Brussels. As the details of the Economic and Financial document have not been released yet, it is difficult to assess whether Italy will be able to respect the 0.6pp structural deficit to comply with the Stability and Growth Pact (SGP). However, unless the European Commission changes its estimate of Italy’s output gap and/or provides substantial fiscal leeway in addition to that granted during the past few years, a general government budget deficit target of 2.4% of GDP over the next three years is unlikely to be compliant. We do not rule out therefore that tensions between Italy and the European Commission could mount in the coming weeks as the government submits a draft budget for 2019 detailing the fiscal measures it plans to take consistent with deficit targets declared. While we can’t completely exclude it, we do not expect Italy will revise down its deficit target substantially. It is very premature at this stage to assessing where such political tensions could lead. It will probably depend on the potential disappointment that Italy would generate in the European Commission because of its aggressive relaxation of structural fiscal consolidation. Should Italy and the European Commission fail to find a compromise, we do not rule out potential re-opening of an excessive deficit procedure from which Italy exited in 2013.
- Rating agencies’ potential response. At the end of October, Moody’s (no precise date set) and S&P (26 October) are due to update their Italian ratings. At present, Italy is rated Baa2 (negative credit watch) by Moody’s, BBB (stable outlook) by S&P, BBB (negative outlook) by Fitch and BBB high (stable outlook) by DBRS. We believe that risks of a downgrade (by one notch) have increased remarkably following the publication of the revised deficit targets. Our assessment is independent of whether Italy and the European Commission will find an agreement on the way forward for the structural consolidation outlook. We believe that the rating agencies’ will likely be influenced by headline fiscal targets. In this regard, the quality and credibility of future primary surplus targets will be critical inputs to the reaction function of credit rating agencies, in addition to their assessment of potential risks stemming from the political outlook.
- Debt sustainability consideration. Against the backdrop of weakening macroeconomic prospects, the likely aggressive deterioration of primary surplus conditions, combined with recent relaxation – and in some cases roll-back – of supply side reform efforts, concerns regarding debt sustainability are likely to resurface, exposing Italy to swings in market confidence. On this specific point, we stick to the view expressed in August: the slowing core fiscal effort combined with weakening pro-growth attitude will put Italy’s debt equilibrium on an increasingly unstable path in the medium term. Following the recent implementation of the growth-unfriendly labour market reform and likely deterioration of primary surplus prospects, we believe that risks of the debt-to-GDP ratio taking an upward sloping path are non-negligible.