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How Much More Can Draghi Do to Save the Euro?

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Wednesday, 30 May 2018 08:01 AM Current | Bio | Archive

Italy I: Gray Swan. Italy always seems to be in a political crisis. Governments don’t last very long there, as the ruling party’s coalition tends to splinter rapidly, requiring yet another election and another effort to form a government by the mostly incompatible coalitions.

This time, after the March 4 election, the latest popular coalition is dominated by so-called “Eurosceptics,” who believe that Italy’s problems might be solved by dropping out of the Eurozone.

This development isn’t a black swan. Rather, it is more like a gray swan. It doesn’t come as a big surprise, yet it wasn’t widely expected either. The question is whether this problem will be contained.

Yesterday, my Outlook inbox included a bunch of messages from accounts wondering whether the latest political mess in Italy might be the trigger for the next global financial crisis, which could trigger a global credit crunch and recession. The short answer is that I don’t think so.

During the various Greek debt crises that started in 2010, there were similar concerns. Yet the problem was contained as the IMF and EU worked out bailout deals with the Greeks.

When the ongoing Greek crisis first started, pessimistic pundits predicted that even if Greece didn’t cause the next global calamity, Italy certainly could do so if push ever came to shove over that country’s messed up financial situation. That didn’t happen because the European Central Bank (ECB) bailed out all the PIIGS by providing ultra-easy monetary policy that allowed these highly indebted “peripheral” Eurozone countries to stay afloat as the ECB purchased their dodgy debts. (The PIIGS are Portugal, Ireland, Italy, Greece, and Spain.)

Consider the following implications of the latest development:

(1) ECB stuck in an easing place. I think it’s safe to say that the Italian crisis will force the ECB to postpone any plans for normalizing monetary policy in the near future. After all, it was the bank’s president, Mario Draghi, who famously declared in a 7/26/12 speech: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” That set the stage for a dramatic drop in government bond yields in the Eurozone through mid-2016 (Fig. 1).

The yield spread between Italian and German bonds narrowed significantly, as did the spread between Spanish and German bonds (Fig. 2). However, on Monday the former spread jumped to 204bps from 162bps the previous Monday (Fig. 3 and Fig. 4). The Spanish-German spread also widened. Nevertheless, the Italian yield remained relatively low at 2.38%, while the Spanish yield was even lower at 1.61%. Contributing to the widening spreads was that the German bond yield fell back down to 0.34%, the lowest since December 18.

(2) Inflation remains well below target. Even before the Italian crisis hit, the ECB was stymied from normalizing monetary policy by the latest CPI reading for the Eurozone. It was up only 1.2% y/y through April, and just 0.7% excluding energy, food, alcohol, and tobacco (Fig. 5). The ECB’s target is 2.0% for inflation. It hit that target during February 2017 mostly as a result of rising energy prices. The core inflation rate has mostly been marking time just south of 1.0% since 2014 despite all the ECB’s efforts to stimulate the economy.

(3) Lending remains weak in PIIGS. Draghi’s ultra-easing monetary policies included a massive QE program, which increased the ECB’s balance sheet from €2.0 trillion at the end of 2014 to €4.6 trillion in late May, led by purchases of “securities of Euro Area Residents in euro” (Fig. 6). In addition, the ECB’s official borrowing rate has been slightly below zero since June 2014.

All that huffing and puffing by Draghi has revived Eurozone lending activity since 2015, but not by a lot (Fig. 7). However, the same cannot be said of Italy, where private-sector net lending by MFIs (monetary financial institutions excluding the ECB) has been mostly negative since the second half of 2011, and increasingly so since mid-2017 (Fig. 8).

(4) TARGET2 divergences widening. The weak link in the Eurozone financial structure may be that despite all of Draghi’s efforts to balance the inherent imbalances among the economies of the region, the imbalances are worsening, according to TARGET2 data (Fig. 9). TARGET2 is an interbank payment system for the real-time processing of cross-border transfers throughout the EU. (“TARGET,” or the Trans-European Automated Real-time Gross Settlement Express Transfer System, was replaced in November 2007 by TARGET2.) The data show that the cross-border transactions within the region were relatively well balanced during the second half of 2008 through the end of 2009. But then the Greek crisis hit in 2010 and threatened to spread to the other PIIGS during 2011. As a result, money poured out of Italy and Spain. It went mostly to Germany.

The imbalances diminished significantly following Draghi’s July 2012 speech. But now they are bigger than ever with surpluses totaling €1.3 trillion during March in Germany, Finland, Luxembourg, and Netherlands. The rest of the Eurozone has a net deficit of €1.0 trillion (Fig. 10).

Hans-Werner Sinn, president of the Munich Ifo Institute, first warned about the increasing TARGET2 balances in a 2/21/11 article in Wirtschaftswoche. He drew attention to the enormous increase in TARGET2 claims held by Germany’s Bundesbank, from €5 billion at the end of 2006 to €326 billion at the end of 2010. He also noted that the liabilities of Greece, Ireland, Portugal, and Spain totaled €340 billion at the end of February 2011. He added that in the event that any of these countries should exit the Eurozone and declare insolvency, Germany’s liability would amount to 33% of their unpaid balances. Wikipedia reports that before Sinn made them public, the deficits or surpluses in the Eurozone’s payments system were usually buried in obscure positions of central bank balance sheets.

(5) Good for US bonds and the dollar. The Italian political crisis helps to remind us why the 10-year US Treasury bond yield has continued to trade well below the growth of nominal GDP in the US, despite the deteriorating outlook for the US fiscal deficit. When global investors are spooked and decide that it’s time to move from a risk-on to a risk-off strategy, they tend to buy US Treasury bonds, which means that they also have to buy US dollars to do so.

The trade-weighted dollar has appreciated 5% since February 1 (Fig. 11). That strength seemed to be fueled by Trump’s protectionist threats. Now the strength is likely to be driven by a weaker euro while we all are waiting to see whether the Italian political crisis morphs into a more serious economic crisis.

Meanwhile, the US Treasury bond yield has clearly been globalized rather than normalized. In normal times, it should be trading around the growth rate of nominal GDP, which is about 4.0%-4.5% currently. Instead, it is back below 3.00% because comparable German and Japanese yields are close to zero (Fig. 12).

(6) More gradual Fed? As Melissa and I noted yesterday, the latest FOMC minutes show that several participants of the FOMC are concerned about the flattening of the yield curve. They noted that it’s been a very reliable indicator of recessions when it has inverted in the past.

Until recently, the yield curve has flattened as the Fed raised the federal funds rate more than bond yields rose in response to the Fed’s hikes. Now several Fed officials might argue for an even more gradual normalization of US monetary policy because the bond yield is falling in reaction to the Italian crisis.

Italy II: More of the Old Normal. “Italy is not Greece. But not all the differences are encouraging. Its economy is 10-times bigger. Its €2.3tn public debt is seven-times bigger; it is the largest in the eurozone and fourth largest in the world. Italy is too big to fail and may be too big to save,” observed a 5/22 FT opinion piece. “The question is whether its new government will trigger such a crisis and, if so, what might follow?,” posed the article’s author Martin Wolf. Indeed, that’s a critical question facing the markets right now.

Sandy, Melissa, and I have been writing about the brewing troubles in Italy since last year. Late last year, Matteo Renzi, the former Italian Prime Minister, bet his job on a reform referendum to streamline the country’s legislative bodies. He lost both, and the country spiraled into political turmoil once again. Eurosceptic leaders were waiting in the wings for Renzi’s Democratic Party (PD) to weaken, as we previously discussed, and it did.

In the March 4 general elections, the anti-establishment Five Star Movement won the largest number of votes, delivering a blow to the governing center-left coalition. Voters were electing the 630 members of the Chamber of Deputies and the 315 elective members of the Senate of the Republic. The League, a rightist anti-immigration party, scored a plurality of seats in the Chamber and the Senate. No group won a majority.

More than two months after the Italians voted, the country’s Parliament continues to hang in the balance. The Five Star Movement was reportedly on the verge of forming a coalition with the League to govern the country. Over the weekend, however, that effort has been blocked by the country’s president. We are not hopeful that it will all be sorted out anytime soon.

If a coalition is successfully formed by the anti-establishment parties, Italy could be on the brink of leaving the euro. The political populists might not even take their Euroscepticism that far. But at a minimum, the new leadership is sure to challenge the status quo in Brussels.

Either way, the latest developments are not too promising in terms of political continuity or stability for the Italian government, which is not too promising for European investors, at least in the foreseeable future.

Consider the following:

(1) Populist coalition blocked. Over the weekend, the country’s President, Sergio Mattarella, blocked the coalition government that Italy’s two leading populist parties were attempting to form. The anti-establishment Five Star Movement and the right-wing League, which had won significant electoral gains during Italy’s March 4 election, failed to gain approval for a slate of ministers in the Italian government.

For finance minister, the populist parties backed Paolo Savona, an 81-year-old Eurosceptic economist and a former Bank of Italy official who has harshly criticized the euro. But the Italian president rejected the choice. Mattarella has the constitutional power to approve or reject cabinet choices.

The 5/25 FT reported that Mattarella is concerned that Eurosceptic leaders could damage Italy’s credibility in both the EU and the markets. We previously wrote that in agreeing to generous tax cuts and big increases to entitlement programs, the two groups appear to be putting Italy on a collision course with the budgetary constraints of the EU. Further, the President said that he feared Savona as finance minister could endanger Italy’s membership in the euro, according to a 5/28 WSJ article.

(2) Ministers in waiting. Meantime, Mattarella asked Carlo Cottarelli, who formerly headed the IMF’s fiscal affairs department and is pro-euro, to try to form a new government as prime minister-designate, reported the WSJ article. It noted: “The move stirred accusations that the president had usurped the popular will expressed in March parliamentary elections.” Taken together, the Five Star Movement and the League won about half of the votes.

Even if Cottarelli is “able to form a new government, the prime minister-designate is unlikely to win a vote of confidence in parliament. Instead, he will likely lead a caretaker government only until fresh elections are called, which could occur in September.” On Sunday, the head of the League said that it “won’t be an election,” but a “referendum” between Italy and the European Union. In his own words: “It will be a referendum between Italy and those on the outside who want us to be a servile, enslaved nation on our knees.”

Last Monday, the populist party leaders settled on Giuseppe Conte, a weak technocrat, as a compromise candidate to lead the populist parties to form a government. Conte was supposed to propose a cabinet to Mattatella this past Friday to be formalized over this past weekend. Instead, an informal meeting was held with the Italian President, and no list of ministers was proposed. On Sunday, Conte gave up his mandate as Cottarelli usurped the caretaker designation.

Yesterday, Cottarelli was expected to present his own list of ministers to Mattarella. But according to an article in yesterday’s FT, the designee asked for one more day to finalize a cabinet. That could suggest that there was trouble brewing with the launch of the newly appointed technocratic administration.

(3) Moody fiscal atmosphere. It didn’t help markets that Bloomberg reported on Friday that Moody’s is considering cutting Italy’s rating. The debt-rating agency is concerned about the proposed Eurosceptic government’s fiscal plans and the possible reversal of past austerity measures. Moody’s said in a statement that coalition parties’ proposals would lead to a weaker fiscal position going forward. Italy’s public debt amounted to €2.3 trillion at the end of March, according to Italy’s central bank. Currently, Italy is rated Baa2, the second-lowest investment-grade rating.

On Monday, prices on Italian bank bonds plummeted as fears of political turmoil weighed heavily on the country’s lenders. Yesterday’s FT observed: “Riskier forms of bank debt that count towards financial institutions’ capital ratios have seen the sharpest sell-off.” Yields on the debt of the world’s oldest bank, Monte dei Paschi di Siena, and Italy’s largest bank, UniCredit, surged on Tuesday.

In response, Ignazio Visco, the governor of the Bank of Italy, warned that the country was close to losing the “asset of trust,” reported yesterday’s MarketWatch. Visco’s comments were a “rare intervention” on behalf of the Italian central bank into the country’s political crisis. In an intentional blow at the two leading populist parties, Visco implied that any new government must respect the EU treaties for debt and deficit limits.

Some speculate that a reprieve to the turmoil in the European bond market might come if the ECB changes its tapering plans. In response to the Italian drama, the bank could decide not to reduce its bond-buying program in September as was previously expected. It’s important to realize, however, that the ECB’s rules allow it to buy government bonds only as long as the country has an investment-grade credit rating.

(4) Crisis for the euro? Adding to the uncertainty across the pond, both parties have openly considered pulling Italy from the euro, regarding it as a failed project. Société Générale’s Kit Juckes told the WSJ that this is not a liquidity issue. It is about a country where the populist parties in charge might not be that keen on being in the euro.

Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.

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EdwardYardeni
If a coalition is successfully formed by the anti-establishment parties, Italy could be on the brink of leaving the euro. The political populists might not even take their Euroscepticism that far. But at a minimum, the new leadership is sure to challenge the status quo in Brussels.
draghi, save, euro, italy
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2018-01-30
Wednesday, 30 May 2018 08:01 AM
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