Options are slipping through Italy’s grasp

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On paper at least, Italy moved beyond the point of no return on Wednesday.  Yields above 7% would require Italy to run consistently high primary budget surpluses (ex. interest rate payments) of 3% to 4% of GDP just to stabilise interest rate costs and prevent them ballooning out of control.  Since the start of EMU, Italy’s primary surplus has averaged just under 2%.  The passing of the budget bill will not bring in the austerity that will overcome the rise in yields. 

What markets have to decide is whether this is primarily an economic or political crisis in Italy.  It’s certainly true that the dynamics are different for Italy.  Greece has not run a primary budget surplus for eight years; Italy has for all but the last two years of the single currency.

The noises coming out of Rome this morning are mildly positive, in as much that the President is recognising that there is not time to wait for elections early next year and former EU Commissioner Mario Monti was made a senator for life, paving the way for him to become interim prime minister.  The reality of the rise in yields, combined with the fact that the EFSF is not sufficiently equipped to deal with Italy, may just be enough to sober up the political elite and send them on the correct course, but it’s a slim chance that has to be seized now. On Wednesday, the euro saw it worst one-day performance since early July, reflecting the growing unease within FX markets at the speed of the sovereign crisis.

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Commentary

 

Europe’s rapidly-changing bond landscape.  Remarkable these days is the incredibly rapid pace of change in bond market relativities within Europe. Indeed, there is a real dichotomy emerging between the winners and the losers.  On Wednesday, the 10yr Italian bond yield soared 60bp to 7.3%, just 60bp below comparable yields in Ireland. Although the focus is very much on Italy, Spain is also in the firing line, with the 10yr yield up another 20bp at 5.82% yesterday, up from 5.0% a month ago. Belgium continues to suffer as well, the 10yr yield up another 10bp yesterday at 4.33%, some 263bp above Germany. To put this into context, Belgian yields have never traded this wide to German Bunds and five years ago Belgian 10yrs were actually trading through Bunds. How times have changed. Unsurprisingly given the massive exposure that French banks have to Italy, French sovereign yields were spanked again, with the 10yr yield up another 10bp on a day when comparable Bund yields were 10bp lower. As a result, the FR/GER 10yr spread widened a further 20bp to almost 150bp, the largest spread for more than two decades.  Apart from German Bunds, it is the Scandi markets, the UK, Holland and Finland that are among the real winners. For instance, the UK 10yr gilt yield dropped a further 10bp yesterday to 2.15%. UK yields continue to register record discounts to France – prior to this year, it was almost unheard of for Gilt yields to trade through those of France. In Germany, the 10yr yield fell a further 10bp yesterday to just 1.7%, a new record low.

Sterling’s usurping of the Swissie.  The reaction of other currencies to this morning’s pressure on Italy has been telling. The dollar is stronger against almost every one of the majors, with the yen holding up the best. Sterling and the Swissie are also weathering the uncertainty relatively well, both having appreciated vs. the euro during the morning. The issue for the Swissie is that the SNB’s decision to do whatever it takes to defend the 1.20 level on EUR/CHF is not without costs. The increase in bank reserves that pushed M0 up 230% in one month risks feeding a credit bubble in the domestic economy, even though prices are now currently falling on the latest CPI measure. Meanwhile, the SNB has continuously made it clear that it still considers the franc over-valued, even at the 1.20 level on EUR/CHF. The SNB’s vice president Jordan expounded on the dilemma currently facing the SNB in comments yesterday, highlighting the “enormously expansionary conditions” that were currently prevailing. For this reason, sterling has been pushing 6mth highs vs. the Swiss franc during this week (around 1.4440), aided by the relative fiscal position of the UK vs. a fair proportion of the eurozone. Furthermore, the BoE’s second round of quantitative easing looks modest in terms of its potential vs. the massive expansion in the Swiss monetary base. It may not last, but sterling is looking like the safe haven of choice within Europe.

Italy moves beyond redemption.  The Berlusconi bounce was short-lived to say the least. As we talked about earlier today, whoever is in charge, the numbers remain the same and this morning they are even worse. The Italian 10yr bond reached 7%; the yield curve is nearly inverted with 2yr paper yielding more than 10yr paper. Yield curve inversion proved to be the death knell for Portugal and also Greece (although not for Ireland). Moreover, the spread over German paper (10yr at 520bp) is at the level at which Portugal was bailed out and not far at all from the level for Ireland.  But this Roman road is currently leading to a cliff. The firepower of the EFSF is simply not sufficient to provide a backstop for Italy. Events have moved far faster than the laboured political process of the EU can deal with. The increase to an effective €440bn lending capacity, as agreed in July, has been ratified but not fully implemented. Meanwhile, the agreement of two weeks ago to increase the firepower further is still being worked through. Regardless, even this would be insufficient by all accounts, and the removal of Italy from the list of EFSF contributors would put increased financial and political burdens on the remainder.  But here’s the issue. At last week’s G20, the US and Asia (read China) effectively said they were not yet prepared to step in because Europe had not done what is required of it. On paper, the eurozone is not in a perilous state, but the issue is that Germany is not prepared to sanction a bailout in the true sense of the word and the ECB will not (some say cannot) go down the road of full quantitative easing because it would amount to the same thing. Right now, pragmatism and ideology could ultimately be the death of the eurozone in its current form.

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