Italy’s failure over the weekend to form a government was driven by the refusal of the Italian President Mattarella to appoint the hardline Eurosceptic Paolo Savona to the position of economy minister. From the perspective of President Mattarella the recent election was not a referendum on the euro; for the Five Star/League coalition his refusal to accept Savona was interference in the democratic process. An incoming caretaker government is being put in place but is not the issue; elections later in the year will in effect be the referendum on the euro. For investors, this creates significant uncertainty over the summer months and into the autumn.
The ECB has been notably silent on developments in Italy, leaving it to Italian central bank head Visco to suggest that only emotional reasons can explain the violent market moves in Italian bond markets yesterday and today. It is difficult to understand why he would say this with Italian 10y bonds showing their worst daily performance in 25 years and short-term interest rates up 50bps since last week, unless he had little else to offer.
We do not expect the situation to die down rapidly but at the same time would also be surprised if ECB policymakers failed to intervene, as the situation now risks getting out of hand. Preventing the break-up of the eurozone has been at the heart of the ECB’s and EU’s policies for most of this decade. However these institutions may have an incentive to show the electorate what it feels like to be out in the cold over the summer months.
While theoretically the proper transmission of monetary policy is well within the mandate of the ECB, it could yet be seen as advantageous for the ECB to demonstrate the negative effects of an anti-EU vote in Italy, while preventing contagion to other markets. Preventing contagion is a task for the present as credit default swap spreads for peripheral eurozone sovereigns and French banks have surged over the last 24 hours. There is an inherent conflict in doing whatever it takes to save the euro when the same liquidity support could potentially be seen to be enabling free-loading populist politicians. The risk is that conditional support may not soothe markets which sense a stand-off. Only today, outgoing ECB vice-President Constancio said in an interview that any ECB intervention must “serve the fulfillment of our mandate” and “meet certain conditions” for any liquidity support.
In our view the Italian fixed income markets were previously priced on the assumption that the ECB would continue to support the market, making credit fundamentals less relevant, and any Italian government would not ultimately lurch in an anti-euro direction, even if populism was growing at the fringes. Both those assumptions have been challenged.
For investors who were cautiously positioned coming into this volatility, we would highlight that the ECB has still not shown its hand. With redenomination risk rising across the eurozone, careful ECB communication will be necessary to calm markets now risk aversion has risen to levels which can no longer be ignored and we would not be surprised to see such a communication in the near future. Eurozone money markets have already moved ahead to discount only one ECB rate increase in 2019, compared to 3 earlier in the year. Ultimately, we believe an Italexit scenario remains unlikely even if the probability may have risen since our commentary last week. However, the immediate question is the risk of another run on eurozone financial institutions, derailing the economic recovery. ECB President Draghi will have to consider whether he will do whatever it takes – all over again.