The prospect of a populist Five Star/League coalition government in Italy has spooked Italian bond markets with yields soaring in recent weeks. Nevertheless, this price move may still be viewed in the context of a correction, given the clearly large difference in fundamental credit quality between Italy and Germany, both from a political level and as measured by the government debt burden as a percent of GDP. It is a situation which is likely to create investor anxiety but the precedent of Greece suggests that the ultimate political power of the EU and ECB is considerable. An “Italexit” scenario would create a high degree of market uncertainty but remains low probability in our view.
The floating of radical proposals by the incoming Five star/League administration, such as the issuance of small denomination and physical government bonds to fund proposed social security initiatives raise the prospect of a parallel currency and subordination of existing government debt. In the circumstances it is no surprise Italian government bonds have sold off sharply, Exhibit 2. While this has been a sharp sell off it should also be put in context; Italy has endured long periods in the current cycle when the spread to bunds was rather higher than now, Exhibit 3. In some respects the anomaly was the ultra-low spread just prior to the increase.
There was a time during 2012 when such a large move in Italian government debt would have caused significant ripples in global markets. The lack of panic in 2018 is in part because the underlying structural problems are well known but also because of the relatively strong global growth outlook at present.
By insulating investors and politicians from the consequences of unsustainable public policies – either in the fiscal domain or in respect of structural reforms which could enable faster growth – the ECB has indirectly supported the growth of populism. Election campaigns conducted under conditions of ECB-enforced market calm have lowered the pressure to deliver sustainable policies, or even those consistent with the continuation of the euro project. It may have been politically helpful for the EU and ECB to stay silent and allow Italian bond yields to rise uncomfortably during the critical period of selection of government ministers.
Furthermore, some of the more extreme policy proposals are unlikely to be implemented given legal constraints in respect of deficit funding and the prohibition of other currencies within the eurozone. We believe investors outside Italy are correct to take a wait-and-see approach for now. Challenges to the EU are not a new phenomenon. The Brexit process has demonstrated that EU negotiations can be of a very long duration and difficult to read. Bearish speculative trades, especially with the mandate the ECB now holds to intervene effectively at will in government bond markets, in the name of the transmission of monetary policy, are no longer a one-way bet.
Importantly, contagion to other regions in the periphery remains limited. Should the situation escalate and Italian yields continue to rise, in the first instance this would only place more power in the hands of the ECB and the EU to provide a financial backstop, but in return for euro-friendly policies and structural reforms. We view this as the most probable scenario, although as with Brexit there is likely to be further volatility along the road.