The Dow Jones Industrial Average was down as much at 505 points today–before rallying to a loss of “just” 391 points or 1.6%–on fears that a crisis in Italy could once again put the entire EuroZone project in danger. Italian stocks were down another 2.65% today in Milan bringing the one-month loss to 10.77%. The yield on the 10-year Italian government bond climbed 48 basis points–that’s huge for a one-day move in a government bond market–to 3.16%. The yield on the safe haven German Bund dropped 8 basis points to 0.26%. That’s how much traders and investors hate Italian debt at the moment.
The good news is that the European Central Bank, thanks to the global financial crisis and the Greek debt crisis, has mechanisms in place to support Italian bonds, Italian banks, and the Italian financial system.
The bad news is that an Italian government has to ask for that help after swearing to be fiscally responsible. At the moment there is, once again, no Italian government. A bid by the populist parties that came in ahead of the field in the latest election was rejected by Italy’s president. They’ve called for new elections–in September. If they win and form a new government, they might not be willing to meet the European Central Bank’s criteria for help because they ran on a platform that opposed the euro as it now exists. The likelihood that the 5 Star Movement and the League would decide to accept the austerity regime required by the European Central Bank as a condition of help is just about nil.
Which leaves the EuroZone with a huge political problem and no clear path out of this mess.
Think back to the “Whatever it takes to save the euro” speech by European Central Bank president Mario Draghi back in the summer of 2012. That speech stabilized the bonds of the weak economies of the EuroZone’s southern members and was backed up, eventually, by a controversial (as in “the German’s hate it”) mechanism called Outright Monetary Transactions or OMT. Under OMT, the European Central Bank can make huge purchases of a country’s bond debt, bringing down yields, and guaranteeing that the country can fund itself.
But…and in this instance it’s a huge “but”…the stressed country must apply for this help and sign up for a rescue under the European Stability Mechanism. A rescue under the ESM requires domestic economic reforms including an austerity program of reduced government spending and lower government deficits. It is precisely the previous austerity program by the European Central Bank that Italy’s two populist parties ran against. Their platform called for an end to austerity and higher government spending. The budget cuts they proposed as part of their platform were laughable. To call them window dressing is an insult to drapery everywhere. But it is extremely likely that these two parties will win a September election with an even bigger share of the vote. And any party that called for a European Central Bank mandated austerity program would face annihilation at the polls. No technocratic caretaker anointed by the President would command the votes in Parliament to deliver what the ESM requires.
So that’s where we stand today. The European Central Bank has a program that would reassure the financial markets in the short run, but there is no viable partner in Italy that would let the bank begin to start buying Italian debt. (There’s also another piece of bad timing. Mario Draghi’s term as central bank president ends this year. There’s talk that it’s Germany’s turn to run the bank. German banking figures almost uniformly hate the bond-buying that’s at the core of OMT. What a European Central Bank run by a German president would decide to do about the Italian debt crisis is a complete mystery. Which, of course, allows speculation to run wild.)
It’s important to remember that the Greek debt crisis largely followed this same political script. A government that agreed to an austerity program was savaged at the polls before a party running against austerity formed a government, which then largely accepted an austerity program but only after global financial markets had administered shocking pain (a depression) to the Greek economy. The Italian crisis could well follow the same course–but I think the 5 Star Movement and the League are stronger parties/movements that would resist an outside austerity program far longer than was the case in Greece. And, of course, the Italian economy is much larger and more central to the EuroZone than Greece was or is. There’s also the change for the worse in the “health” of the euro represented by Brexit. The euro is under more stress today by some measures than it was back in the day of the Greek crisis. It’s hard to imagine the euro project continuing in anything like it’s current shape if both the United Kingdom and Italy leave the currency.
Even from today’s results you can see the sweeping effects of this crisis.
Markets have moved decisively away from risk assets. The iShares MSCI Emerging Markets ETF (EEM) fell 1.08% today and at $45.35 closed below both the 50-day moving average (at $47.22) and the 200-day moving average (at $46.99).
Traders and investors have moved toward safe havens–even if they are only relatively safe havens. The Dollar Spot Index, which tracks the dollar against a basket of global currencies, gained 0.4% to the highest level in five months. The dollar also climbed against the euro with the euro falling 0.8% to the lowest level in 10 months. The Japanese yen rose 0.7% against the dollar to the highest level in five weeks.
The shift in risk on/risk off thinking has upset the trajectory of other trends. U.S. Treasuries, after sinking on a conviction that the Federal Reserve would raise interest rates at least two more times this year, have rallied as money has flowed into this market in a search for liquidity and safety. Today the yield on the 10-year U.S. Treasury, which was flirting with 3.1% not all that long ago, fell 15 basis points to 2.78%. Even with the Federal Reserve almost certain to raise interest rates at its June meeting, I think the Italian crisis will be enough to keep yields on the 10-year Treasury below 3% for a while.
“For a while”–that’s the key phrase here.
How long will this crisis last?
With signs that the 5 Star Movement and the League fully intend to use the rejection of their bid to form a government as a rallying point, I don’t see a quiet summer for Italian politics. That’s likely to mean that while we’ll get soothing words from Mario Draghi and the European Central Bank, we won’t get much in the way of actual action since there is no partner to negotiate with in Italy.
To me this argues that the crisis is with us–and will quite possibly seem worse as it drags on–into September at least.
If you believe the crisis won’t last nearly that long, then you should be willing to just tough it out with your current portfolio positioning.
If you believe in my September or worse scenario, you should be rejigging your portfolio now. I’ll have suggestions for that in a post tomorrow.