Dear Italy: You Now Stand Accused Of ‘Unprecedented’ Crimes Against Budget Discipline

Speaking to reporters in Rome after a meeting with the E.U.’s Pierre Moscovici, Italian Finance Minister Giovanni Tria said this on Thursday:

We and the E.U. have different views on Italy’s policies.

That’s a candidate for understatement of the year.

If you ask Moscovici, Italy’s draft budget for 2019 doesn’t just represent a difference of opinions. Rather, it represents “an obvious significant deviation” from the bloc’s rules. That, according to a letter to Tria penned by Moscovici and fellow E.U. Commissioner Valdis Dombrovskis, who characterized the deviation from Brussels’ recommendations as “unprecedented in the history of the Stability and Growth Pact.”

Europe’s assessment of Italy’s proposal is ongoing, but suffice to say the Commission is now warning of “particularly serious non-compliance with budgetary policy obligations”. That characterization certainly does not bode well for Italian assets which have been besieged by selling pretty much non-stop since Deputy PMs Matteo Salvini and Luigi Di Maio brushed aside Tria’s warnings on the way to setting a deficit target they knew would create problems late last month.

Last week, Reuters reported that the ECB will not come to Italy’s aid in the event the government or the financial system runs out of money barring a formal bailout request, setting the stage for a pretty epic showdown at some point in the not-so-distant future.

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Ruh-Roh! ECB Won’t Rescue Italy, May Force Populists Into E.U. Bailout

As budget fears mounted, the nefarious “lo spread” ballooned out to 326bps on Thursday, the widest since 2013:

(Bloomberg)

“The slow drift in Italian bond futures to the day’s low comes amid the highest volume in a week for this time of day and it coincided with the results of the BTP Italia bond swap, where most of the sales of nominal debt in the exchange were concentrated on the front end”, Bloomberg’s Kristine Aquino wrote earlier Thursday, adding that while it’s never a good idea to mistake correlation for causation, “heightened focus on what is typically not an exciting event for investors speaks to the depth of Italy-related jitters still out there.” Here’s BTP futs since things started to go awry late last month:

(Bloomberg) 

Obviously, the higher yields go the more perilous Italy’s debt dynamics. “[Italy’s] deficit comes only from the interest payments, but of course that means the other way round, when the interest rates go up, the deficit will rise again,” the ECB’s Ewald Nowotny said today in Vienna.

This all comes ahead of a giant hurdle for Italian bonds at the end of this month when S&P and Moody’s will pass judgement on recent events. There’s a potentially dangerous setup here wherein expectations beget reality in a self-reinforcing loop as investors sell ahead of an expected downgrade making the downgrade more likely. Here’s a scenario analysis from a Goldman note dated Tuesday:

Our subjective assessment is that market participants are now focused on four potential rating scenarios for Italian debt in the coming weeks, with current prices reflecting a probability weighted average of these potential outcomes (Exhibit 2).

1. No downgrade scenario: We believe such an outcome would be positive for BTPs, with spreads potentially returning to the 200-250bp range observed in the second half of May, before the initiation of the sovereign rating review from Moody’s.
2. One-notch downgrade scenario: This outcome constitutes, in our view, the market ‘base case’ and we think it is the most likely outcome. Under this scenario we think spreads will oscillate in the 250-300bp range, in line with the price levels observed in August and September, before the publication of the updated Stability Programme.
3. One-notch downgrade scenario and negative outlook: We think this scenario would be negative for BTPs, with spreads trading in the 300-350bp range. However, the risk of an intensification of the negative feedback loop between sovereign risk, the banking sector and, ultimately, growth could implicitly increase the probability of further negative rating actions.
4. Two-notch downgrade scenario: In our view, this outcome would be very negative for BTPs, paving the way to highly non-linear price dynamics, with spreads potentially exceeding 400bp. We view this scenario as very unlikely in this round of ratings updates.

Here, in case you need a stark reminder, is how Italian financials have fared since late April:

You can thank Salvini and Di Maio for that, which brings me right back to the same point I continue to make when it comes to Italy’s fiscal trajectory under the populists: They (the populists) can rant and rave until the cows come home, but the reality of this situation is that without an ECB backstop, the market is going to punish them for fiscal profligacy.

So at some point, Salvini and Di Maio are going to need to decide whether they want to live with their decisions where that means accepting the verdict of price discovery in the post-PSPP/CSPP world, or else give in and go hat in hand asking for a bailout.

They can’t have it both ways.