ITALY AND "RO,RO" / PRUDENTBEAR.COM

Italy and "Ro, Ro"

by Doug Noland

March 01, 2013



It was a relatively quiet Monday, with the Dow flirting with all-time highs.Initial reports from the Italian election had the front-running coalition, led by Pier Luigi Bersani, coasting to victory. Italian 10-year bonds were rallying sharply, with yields sinking as much as 27 bps to 4.17%. The euro was gaining about 1%, trading above 1.33 versus the dollar and above 125 against the yen. Basically, it was business as usual for highly speculative global markets, as the bulls chuckled “told you so!” That is, before all hell about broke loose in the currencies.



Various exit poll projections began painting a quite different picture of what had transpired with Italy’s electorate. The presumptive Prime Minister’s (Bersani) left-leaning coalition was not receiving the expected support. Instead, the big election surprise was the strong performance of comedian Beppe Grillo’s Five Start Movement. 

Worse yet, Silvio Berlusconi, the disgraced former Prime Minister not long ago given up for dead, was proving himself the cagey cat with nine lives. His right-leaning coalition was doing better-than-expected, with a chance to deny Bersani (perhaps even in alliance with Monti) a majority in Italy’s Senate. And, perhaps worst of all for European leaders and the markets, Caretaker Prime Minister Mario Monti’s coalition was looking like an election disaster. It became a distinct possibility that no party would garner sufficient control in the two houses of Parliament to appoint a leader for a new Italian government.

Suddenly, complacency gave way to trepidation of a “hung parliament” and the potential for an “ungovernable” Italy (the world’s third largest debtor nation!). At least in the currencies, the reaction was rather swift and ferocious. After trading above 1.330, the euro sank to 1.305 to the dollar by the end of the day.  

The really stunning move, however, was in the euro/yen. After trading above 125 in the morning, the euro/yen “cross” traded below 119 by late-afternoon. The yen rallied more than 4% against the euro and, curiously, almost 3% against the dollar.

The Wall Street Journal and others have highlighted the recent big macro hedge fund profits achieved by betting aggressively against the yen. Monday’s Italian election-induced reversal in the yen kicked the yen bears in the teeth. It will now be interesting to see if the yen reversal marks a key inflection point for the global “risk on” backdrop that has captivated the investing and speculating world in recent months – and provoked ebullient predictions of a new bull market.

So, one might ask, why is the Italian election a big deal for Europe, the euro, the yen, global “risk on” and the supposed “new bull” in U.S. equities? This past summer, the Draghi Plan (Outright Monetary Transactions/OMT) singlehandedly transformed European securities from the leveraged speculating communities’ preferred shorts to their must-have longs. This reversal of speculative finance (“hot money”) dramatically altered financial conditions throughout Europe, while strongly bolstering the flagging euro currency (not to mention confidence in European financial institutions). Importantly, Draghi (with help from the Fed and global central bankers) removed the near-term tail-risk catalyst impeding global “risk on” - and held a potentially problematic global systemic crisis at bay.

Crisis risk in Europe was viewed as having been taken off the table, while the Fed’s $85bn monthly QE would also pressure the dollar and generally support speculation and inflating global risk markets (pro-“risk on”). Meanwhile, the new Abe government in Japan was seen supporting radical monetary stimulus to weaken the yen and jumpstart the moribund Japanese economy. For more than two years, the prospect of a bout of European-induced “risk off” had bolstered the safe haven appeal of the yen. Now, the big sophisticated “macro” hedge funds saw their long-awaited opportunity for a big one-way bearish play against Japan’s susceptible currency. The Japanese wanted their currency lower and global risk markets were in a favorable state of “risk on” that itself created an overhang pressuring the yen (along with other perceived safe havens). At the same time, selling yen to finance higher yielding securities in stronger currencies also worked to bolster global “risk on.” 
  
On the back of the Draghi Plan backstop and resulting “risk on,” Italian yields dropped from August highs of 6.5% to recent lows of 4.13%. Spain’s 10-year yields sank from 7.60% to a low of 4.87%. For Portugal, yields collapsed from about 14% to less than 6%. Similar drops profoundly altered the financial environment for Ireland and even Greece – if not economic fundamentals throughout the region. 
 
After trading as low as 4.17% Monday, Italian 10-year yields surged as high as 4.93% Tuesday when the election outcome had become clear. Italy bond yields closed Friday at 4.79%, up 34 bps for the week. Spain’s 10-year yield traded as high as 5.59% Tuesday, before ending the week down 5 bps to 5.10%. Portuguese yields traded as high as 6.54% before closing the week 8 bps higher at 6.30%. 


Post-election headlines have been telling: From the Financial Times: “Fears ECB Bond Scheme Has Its Weakness;” “Italian Poll Disarms ECB’s Bazooka;” “Voters in South Europe Grow Weary of Austerity;” and “The Vandal that Wants to Sack Rome’s Politicians.” And from Reuters: “Italy Election Punches Hole in ECB’s Euro Defenses” and “Grim Jobless, Debt Figures Underscore Italy’s Crisis.”

Thursday from Reuters (Paul Carrel): “A dramatic anti-austerity vote leaves Italy lying outside the fortress the European Central Bank constructed around the euro zone last year and vulnerable to a market attack. This week's election leaves slim prospects for a durable, reform-minded government in Rome and exposes a flaw in the bond-buying defense plan the ECB put together last September - a weakness that could see the euro zone crisis roar back to life. After vowing to do ‘whatever it takes’ to save the euro, the ECB’s Italian chief Mario Draghi launched a plan - dubbed Outright Monetary Transactions (OMT) - in September which promised potentially unlimited buying of a struggling country’s bonds… The catch is Draghi is ready to do whatever it takes ‘within our mandate’. To satisfy this caveat, the scheme requires a country whose bonds the ECB buys to sign up to a European aid program with debt-cutting conditions attached.”

The markets have confidently dismissed the ECB’s “conditionality” clause. When Draghi stated we’ll do “whatever it takes” while staying “within our mandate,” the markets heard “whatever it takes” and immediately stopped listening. The markets view “conditionality” as having been necessary at the time to garner support at the ECB for a commitment to open-ended market intervention. The assumption is that Draghi would resort to aggressive market intervention as necessary to support European bonds and the euro – one way or another. This may be way too complacent.

Reuters quoted ECB Executive Board member Benoit Coeure: “If yields go up because of political events, there is not much the ECB can do, that’s not related to monetary policy whatsoever.” Also from Reuters: “Sources close to the ECB are conscious of the risk of contagion from Italy to Spain, but insist it will not intervene to help Italy if it does not have a credible government capable of the reforms required for support in the debt market.” Facing a potentially difficult situation, the Italian Draghi this week stated, “We do not act to help governments. We act to help maintain the flow of credit to real firms and households. Governments need to address the structural problems in their economies.”

The Bundesbank has been adamantly opposed to the OMT market backstop from day one. Mr. Weidmann has been outspoken in his questioning the legality of the ECB providing monetary financing (“printing” and bailouts) for troubled debtor countries.

The backdrop turns further complicated after the strong anti-German tone to Italian campaign rhetoric. The Italian electorate essentially voted against EU imposed “austerity” they believe is being dictated by Berlin. Berlusconi and Grillo ran campaigns critical of both the loss of sovereignty to European mandates and the euro currency more generally (Grillo has called for a public referendum on the euro). Friday from Bloomberg: “CDU [Merkel’s party] lawmaker Klaus-Peter Willsch says if the majority of Italians cannot be convinced to stand by EMU rules, the country must be allowed to return to its own currency, Handelsblatt says… Monetary union will only survive if it benefits all its members.” President Napolitano canceled a scheduled meeting with the candidate running against Chancellor Merkel in Germany’s September elections, after Peer Steinbrueck was quoted as saying he was “horrified that two clowns won the election.” One can ponder the outcome if Germany’s Bundestag is ever called upon to vote for what would be a very large bailout package for Italy.

There are serious long-term ramifications for the rise of anti-European integration populism in Italy and throughout Europe. For now, the pressing issue is whether Italy can cobble together a functioning government. Grillo’s independent Five Star Movement actually received the most votes of any individual party. He has nothing but acrimony for the establishment – essentially calling for the downfall of the traditional dominating political parties. Grillo has had particularly harsh words for Bersani, while stating that he will not join a coalition with either Bersani or Berlusconi. Meanwhile, Bersani and Berlusconi despise each other. And new corruption charges against Berlusconi have his supporters livid. New elections may be necessary, although it doesn’t appear Bersani, Berlusconi or Grillo prefer that route for now. Complicating matters, the term of Italy’s President (Giorgio Napolitano) – who has a traditional role dissolving parliaments, calling for new elections and brokering alliances – ends next month. Some type of “loose” – and likely dysfunctional – coalition government seems likely.

Beyond the short-term, there is increasing risk that the Italian people at some point completely reject “austerity” and call for a return of the lira. Friday’s data highlighted the problem. The Italian unemployment rate was up another 40 basis points in February to a worse-than-expected 11.7%, the high since 1992 (youth unemployment almost 40%). Italy’s PMI Manufacturing index dropped 2 points to a worse-than-expected 45.8. In Italy and throughout the euro-zone, the lack of economic response to dramatically loosened financial conditions and strong securities markets has been striking. Friday data had euro-zone unemployment up to a record high 11.9% - and counting. 

Disconcerting economic developments were not limited this week to continental Europe. Talk turned to “triple dip recession” after the U.K. manufacturing index for February unexpectedly dropped to 47.9. Canada reported the weakest GDP growth (0.6%) in almost two years. China’s manufacturing indices were weaker-than-expected, perhaps indicating an economy more vulnerable than generally assumed. There were also more rumblings of rising home prices and Chinese resolve in tightening mortgage finance. India reported weaker-than-expected Q4 GDP (4.5% vs. estimates of 4.9%). 

Meanwhile, automatic “sequester” budget cuts went into effect Friday here in the U.S. And whether it is the U.S., China, India, Brazil or “developing” economies more generally, I remain troubled by this dynamic of marginal economic growth in the face of ongoing rapid Credit expansion. I believe this creates heightened vulnerability to a reemergence of global de-risking/de-leveraging dynamics.

The world’s markets have enjoyed six months of powerful “risk on” gains. There has been a veritable flood of “money” into equities and global risk markets more generally. In the U.S., in particular, talk of a new bull market has coaxed previously cautious holdouts back into equities. And I have no reason to believe the bulls will give up their strong market position/domination without one heck of a fight. Yet markets do have an inflection point – “risk on” succumbing to “risk off” – tone to them.

Indicative of a change in trend, volatility has become more pronounced throughout the markets. It has become particularly treacherous throughout the currencies. And after gaining almost 10% in January, Italian stocks now post a 2013 decline of 3.7%. With the exception of the U.K., most European bourses have given back much or all of early-year advances. The same can be said for many key “developing” markets. India’s Sensex index is now down 2.6% y-t-d. Brazil’s Bovespa has lost 6.7%, while Mexico’s Bolsa is up just 70 bps. 

Most “emerging” currencies were under pressure this week - and thus far for 2013 overall. Eastern Europe’s equities and currencies were on the defensive again this week. The Goldman Sachs Commodities index fell 2.4% this week (up 0.3% y-d-t) and is now about 5% below mid-February trading highs. 
 
U.S. stocks again held their own this week, as the chasm between fundamental prospects and securities market prices widens further. “Safe haven” Treasuries and bunds (and gilts?) enjoyed notably robust demand this week. The bulls were pleased with assurances that chairman Bernanke is not about to flinch on his “money” printing operation. And, you know, I see no reason not to expect next week to provide another “new and exciting adventure” in the workings of speculative “high” finance.