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The Curious Incident of the Dog That is Barking Loudly

We have repeatedly pointed out that the monetary stimulus and support that the European Central Bank provides to Eurozone member nations, companies and people is not just for fighting economic slumps caused by events like the global financial crisis and the Covid pandemic, but to try and compress sovereign yields. ECB President Draghi in 2012 laid down his ‘Whatever it takes..’ mantra and the ECB has (mostly) marched along to this tune since then.

Now that markets are taking the view that the ECB will be hiking rates this year, and may actually turn ‘hawkish’, the sell off in the German bond market is hitting the biggest Eurozone risk of all – Italian debt. This has been a slow avalanche to some extent, but it is gathering speed. To those looking for warning signs of turbulence within the Eurozone the risks of more populist policies, the split in views on what to do if Russia invades Ukraine and now the potential return of investors dumping some Eurozone national debt and letting spreads widen will poison the view that the Eurozone is heading towards a functional national entity. Long suffering currency analysts (ahem…) who continue to think that the EUR is a doomed project will be dusting off their musings and thinking that this is it, the shackles of the EUR will come off and Greece, Italy, Spain, Portugal etc. can fly free again with their own currencies bringing opportunities and discipline to their countries.

Easy tiger. Odds are that many leaders in the Eurozone like the shackles of the single currency, as they are outweighed by the ECB support. For asset managers? While the temptation is to join hedge funds and prop traders and play the widening spread trades – and to some extent risk management will do this for you – a long term view may be to try and think about how wide the spread between the Italian 10-yr. BTP can get over the Germany 10-yr. bund yield before you step in and say ‘thank you very much!’ again. In other words, EUR breakup hopes may be dashed again, and Italian bonds may find support from the ECB again.

Italian politics will play a role in the longer term too. Draghi is staying on as Prime Minister for now, after President Mattarella (aged 80) was persuaded to stay on a bit longer. But Draghi will likely move to the Presidency next year when elections are due. At the least the pace of economic reforms will likely slow then, and there is a risk that populist politics reappears, especially if servicing the debt burden start to look problematic.

The Italian debt problem has got a whole lot worse, as the debt-to-GDP chart below shows.

The blowout in 2020 is of course, an unfair metric to ponder over. But how long will it take to bring this down to ‘more reasonable levels’. At some point somebody may remember that EUR membership rules used to have a ‘less than 60% debt-to-GDP ratio’ rule. Italy has never been close to this.

The charts below show the Italian yield, the 10-yr. bond yield and the spread chart of the Italian 10-yr. over the Germany 10-yr. yield. A 38.2% retracement of the broad tumble in the spread from 550 bp to 90 bp (2011 to 2015) comes in near 265 bp, the 50% retracement is near 375 bp and the 61.8% retracement is near 435 bp (near 160 bp now, around 90 bp a year ago). The spread widening could stop on a dime if the ECB comes out and says ‘Pfft, we aren’t hiking rates until 2023 at the earliest, and even then we will be lucky to get rates into positive territory by 2025’ or something like that. Additionally, they could say ‘We love Italian bonds and plan to hoover them up until the 10-yr. spread over German debt gets down to single digits…’. Hmm… These seem unlikely as the ECB looks to be juggling roaring chainsaws here as they try to remove the ‘punch bowl’, balancing growth, inflation and still trying to deal with the broken transmission mechanism that plagues the Eurozone as sovereign risk matters and national bond yields can blow out now and then.

Gerry Celaya,

Chief Strategist


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