What’s next for Italy?

Summary:

Political chaos in Italy spoils market moods
Surging bond yields revive debt sustainability concerns
ECB has ways to support the Italian bond market
EURUSD defends the key support
DE30 picks up but outlook mixed

What’s the problem?

Why are markets so obsessed about the Italy in the first place? We had various political risks and turmoils across Europe over the past few years and often the repercussions on the markets were less dramatic. Well just look at the chart below – the debt/GDP ratio is among the highest in the World. Furthermore Italy has a problem of competitiveness which constraints growth rates. Think about it – if the economy grows 3% in nominal terms (1.5% real growth and 1.5% inflation) which is somewhat optimistic anyway, you need debt servicing cost no higher than 2.3% just to keep the ratio stable. Years of unprecedented stimulus from the ECB and a relative stability in Italy helped deliver yields lower than this level but now as the market turmoil intensifies it becomes self-sustaining – the more bond yields increase the worse the outlook so bond yields increase again and so on…

Italy needs low interest rates to service its debt. Source: Tradingeconomics.com

Politics – awaiting elections

As populist government formed by the M5S and the League has been blocked by president Matarella what we do know nearly for sure is that Italy is headed for another elections, the question is “when”. It looks like the later the better for two reasons – it’s time for the markets to chill and if there’s interim government we could have at least 1 decent budget. There are three options:

January – if Carlo Cottarelli (interim PM named by the president) has support for the budget which seems extremely unlikely
September – if Cottarelli fails to get at least temporary support
July – if president Matarella sees enough backing from the parties

It’s worth noting that the outcome is not going to get “better” from the market’s point of view. Pro-market PD has gained only marginally in polls and is set to remain in the opposition. M5S is still projected to win but has seen slightly lowered support and might refer delayed election to contain the rise of the extreme-right League that’s been gaining massively in the polls. The League is the most anti-Europe party so its rise is certainly not a welcome phenomenon and thus investors would rather prefer later date so Italians could think twice before voting.

New elections could produce even scarier political scene in Italy. Source: Bloomberg, XTB Research

ECB – can the central bank help?

Yes it can. There are various ways the ECB could support the Italian bond market:

QE tweaks – The ECB has still 120 billions euro of debt to buy until the end of September and some more in the final quarter and it could tilt these purchases towards the Italian debt. Because Italian debt is so huge the ECB could technically buy another 150 billion euro of it before it could hit the capital key ceiling. Even if (and that’s not been decided yet) the QE ends this year the ECB could prefer the Italian debt throughout the reinvestment process which could last for years.
OMT – on paper this is the most powerful tool. Introduced at the pinnacle of the eurocrisis but never used, the tool allows the ECB to buy government bonds to stabilize yields. Sounds good? The problem is that the country needs to apply for the program and have the reforms package approved by the ESM. Will the populist government elected on criticizing austerity follow that path? Seems unlikely but for the markets it’s the eventual backstop anyway (just look at Syriza in Greece).
TLTRO – the ECB could drop free loans on Italian banks or actually pay them if they lend this money into the economy reducing a risk of the banking crisis

This is the reason why we think it’s too early for a full blows crisis in Italy. For as long as the markets see a hope present fears can be contained.

EURUSD

In previous analyses we presented the 1.1550 as the key support for the EURUSD. Not only has it been reached but it seems to be respected by the markets. Reaction this week is absolutely crucial – bearish momentum leading down to this level was huge so any reversal needs to be equally impressive if it’s about to last.

DE30

The evening star formation on D1 which we highlighted last week worked out and led to steep declines on DE30. Now the key 12600 support has been in play and allows for some bullish action. However, longer term outlook is not that rosy – declines took place on a massive volume and with a trend line broken a renewed selling pressure could be just a matter of time. We will see if a rebound is strong enough to at least retest Tuesday’s open at 12860 points.