Via Damien Boey at Credit Suisse:
More chaos in Italian politics and bond markets
Italy’s prime minister-designate Conte has given up on his mandate to form a populist coalition government after talks with President Mattarella collapsed. The likelihood is that fresh elections will need to be held later this year. In response to the news, Italian bonds sold off sharply, while German bunds rallied. The Italian-German sovereign spread now stands at 234bps – the widest level since late 2013.
Investors have also been closely monitoring developments in Spain, where Prime Minister Rajoy is facing a no-confidence vote this Friday. Spanish bonds have been much better behaved than their Italian counterparts, but there is no doubt that concerns are growing about the health of peripheral Europe.
We have highlighted in previous articles that the single best leading indicator of peripheral European sovereign spreads to bunds is the dispersion of real GDP growth outcomes in the region. The higher growth dispersion becomes, the less suitable the monetary union is as a “one size fits all” solution, and the more pressure there is on member states to consider exiting.
Up until very recently, spreads have been artificially held down by the legacy of ECB quantitative easing – but growth dispersion has been on the rise. Against this backdrop, and notwithstanding recent political developments, we think that we are merely witnessing a normalization of risk pricing, rather than an outright panic.
Our problem is that going forward, the risk is that the European economy comes close to stalling on the back of tighter financial conditions. Our proprietary financial conditions index for Europe, based on first principles, is pointing to growth slowing sharply on the back of shrinking real wages, an excessively strong EUR, and a flat real yield curve. And as growth slows sharply, Germany will likely be holding up the regional aggregates, implying that peripheral nations will verge on contraction. In other words, growth dispersion tends to increase as growth slows.
For the economies that face a sharp slowdown, the problem is that if the ECB chooses to exit quantitative easing, government deficit spending will no longer be a “risk free” exercise. In the quantitative easing era, investors have had the benefit of knowing that any primary issuance they bought in peripheral Europe could be easily on sold to the ECB in the secondary market. In other words, the ECB enabled member states to borrow from the market on risk free terms, without providing them direct monetary financing. If this privilege is no longer available, peripheral European governments will struggle to stimulate their economies as growth slows, and in turn, this exacerbates de-leveraging risks.
Of course, prior to the inception of the EUR, Italy’s policy was always to devalue the lira. But under the monetary union, this is not an option … and in this context, the excessively strong EUR is something to worry about.
European financial conditions, and growth dispersion have historically been very powerful drivers of European banks performance. Easier (tighter) financial conditions, and lower (higher) growth dispersion have historically been consistent with European banks outperforming (underperforming). But the current mix is not supportive of outperformance. Tightening financial conditions and rising growth dispersion are having a negative impact on credit pricing in the region, with negative flow effects for banks. In the year-to-date, European banks have underperformed the market by 11%.
Risks in Europe also cause safehaven demand for bonds to rise. Reflecting this logic, there is a strong and positive correlation between European banks relative performance and 10-year bond yields (in the US and Australia). With European banks and peripheral European government bonds sharply underperforming, it is no surprise to see that government bonds elsewhere have started to rally.
To be sure, we are not predicting a breakup of the monetary union. All we are saying is that the prevailing risks, which we can capture in a few simple metrics, are enough to justify risk-off positioning for now. Indeed, we think that it is more likely that the ECB postpones, or abandons its quantitative easing exit plans, than it is that Italy or Spain exits the monetary union. But even in this more benign scenario, there must be more room for bonds to rally, and the safehaven appeal of the USD to increase.
- Italy is entering crisis and it’s going to take quite a while to sort out;
- it is large enough to suck in the entire Eurozone and re-pose fundamental questions about the viability of EUR;
- yet markets are hilariously long EUR and ECB tightening;
- the USD is going keep rising and push the contagion into emerging markets;
- wholesale funding costs worldwide will begin to rise so here comes another blow to Aussie banks, and
- the AUD is going to keep falling.