Ah, Italy. My people; fun to be around, a nightmare to govern. And now an existential threat to the European Union, the euro currency, and the global bond markets.
After suffering for over a decade under a monetary regime designed by and for efficient economies like Germany, the Italian people have finally said enough, giving a majority of their votes in this month’s election to parties that promise relief – though rather different forms of relief – from the burdens of a stable currency. From last week’s Guardian UK:
Italy’s new government, likely to be formally confirmed within the next few days, sets a perilous precedent for Brussels: it marks the first time a founding member of the EU has been led by populist, anti-EU forces. From the EU’s perspective, the coalition of the anti-establishment Five Star Movement (M5S) and the far-right League looks headstrong and unpredictable, possibly even combustible. Leaked drafts of their government ‘contract’ include provision for a ‘conciliation committee’ to settle expected disagreements.
Mainly it looks alarming. Both parties toned down their fiercest anti-EU rhetoric during the election campaign, dropping previous calls for a referendum on eurozone membership… But as they approach power, the historical Euroscepticism of the M5S and the League is resurfacing. An incendiary early version of their accord called for the renegotiation of EU treaties, the creation of a euro opt-out mechanism, a reduction in Italy’s contribution to the EU budget and the cancellation of €250bn (£219bn) of Italian government debt.
It’s important to remember that until very recently Italy’s short-term government paper traded with negative yields. That is, if you wanted to lend them money you had to pay them rather than the other way around. This was largely because everyone assumed that the European Central Bank would give Italy effectively unlimited amounts of credit to ensure that it stuck around and played nice.
Now, not so much. Italian bond yields are spiking and spreads relative to German and other supposedly risk-free bonds are rising. And the ECB feels no compulsion to bail out this particular set of Italian politicians.
What exactly does this mean for the euro? Well, that depends on whether the new government follows through on its voters’ desire to start prepping for a departure from the eurozone and a return to the lira – a currency that can be devalued at Rome’s pleasure.
Were this to happen, Italian paper worth hundreds of billions of euros would …well…it’s not clear what it would do. If Italy converted its outstanding debt to lira that would be a breach of contract, triggering a legal orgy with wholly unpredictable consequences, one of which might be its banishment from the global money markets. If Italy tried to leave the EU, we can take the never-ending Brexit quagmire and raise it an order of magnitude, and even then we’re probably underestimating the disruption.
Is Italy Just Another Emerging Market?
It might be helpful to stop thinking of Italy – and several other “peripheral” EU members — as advanced developed countries and instead put them in the “emerging market” category. In which case they have lots of company. From Doug Noland’s most recent Credit Bubble Bulletin:
Where to begin? Contagion… The Argentine peso dropped another 5.0% this week, bringing y-t-d losses to 23.7%. The Turkish lira fell 3.9%, boosting 2018 losses to 15.4%. As notable, the Brazilian real dropped 3.7% (down 11.5% y-t-d), and the South African rand sank 4.0% (down 3.0% y-t-d). The Colombian peso fell 3.0%, the Chilean peso 2.7%, the Mexican peso 2.7%, the Hungarian forint 2.3%, the Polish zloty 2.1% and the Czech koruna 2.0%.
EM losses were not limited to the currencies. Yields continued surging throughout EM. Notable rises this week in local EM bonds include 54 bps in Brazil, 27 bps in South Africa, 34 bps in Hungary, 36 bps in Lebanon, 25 bps in Indonesia, 28 bps in Peru, 14 bps in Turkey, 20 bps in Mexico and 11 bps in Poland.
Dollar-denominated EM debt was anything but immune. Turkey’s 10-year dollar bond yields spiked 41 bps to 7.16%, the high going back to May 2009. Brazil’s dollar bond yields surged 29 bps to 5.58%, the highest level since December 2016. Mexico’s dollar yields jumped 18 bps to 4.64%, the high going all the way back to February 2011. Dollar yields rose 19 bps in Chile, 28 bps in Colombia, 19 bps in Indonesia, 14 bps in Russia, 14 bps in Ukraine and 167 bps in Venezuela (to 32.80%). Losses are mounting quickly for those speculating in EM debt.
Bonds throughout the euro zone periphery were under pressure. Greek 10-year yields surged 50 bps to a 2018 high 4.50%. Portuguese yields jumped 19 bps to 1.87%, and Spanish yields gained 17 bps to 1.44%. Elsewhere, Australian 10-year yields rose 12 bps to 2.90%, and New Zealand yields rose 14 bps to 2.86%.
There’s a recurring “death spiral” element to emerging market debt, in which these countries temporarily stabilize their finances, get cocky, start borrowing in major currencies like the dollar on the assumption that their local currencies will continue to strengthen, thus allowing them to pay off their external currency loans with ease…and then fall prey to traditional overspending, corruption and inflation temptations, causing their currencies to fall and their debts to become unmanageable.
Here we go again, with the added twist of populist political parties rising around the world, promising to extricate their countries from the clutches of elite parasites.
If this has a “2008” feel to it, that’s because crises frequently begin at the periphery and move towards the core. Initially the core markets and asset classes watch with smug amusement as the hinterlands burn while terrified capital flows to the center, actually boosting the value of core assets.
But in the end everybody (except for short sellers and gold bugs) pays a price for each generation’s late-cycle hubris.