News in Charts: Risks Back On-Italy Debt
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As we highlighted in last month’s forecast, markets started the year with a sense of euphoria at the passing of two key risks: the US fiscal cliff; and the euro crisis. The events of the past few days have given markets a nasty jolt on both fronts. In Italy, election results provided no clear winner, raising the prospect of a weak coalition government, or fresh elections, or both. Two months into 2013, in a year in which it needs to roll over $380 billion of sovereign Italy debt, Italy finds itself effectively with no government, and consequently no credible mechanism in place with which to close its fiscal deficit. The events of the past few days serve as a stark reminder that, without fiscal transfers, and without a banking union, the euro crisis was never resolved. Instead, it has been lying dormant, ready to awaken at any time.
Italy’s inconclusive election result led to a sharp sell-off in peripheral euro area equities and government bonds. Investors took fright as results showed that the Centre-Left party led by Pier Luigi Bersani, despite winning in the lower house, was defeated in the Senate by Silvio Berlusconi’s Centre-Right bloc. A majority in both houses is needed to rule. Meanwhile the choice of markets and the rest of Europe, Mario Monti, came in a distant fourth, collecting just 10% of the vote.
The uncertainty has weighed on markets and may result in fresh elections. Some have raised this as a source of concern, believing it will help the anti-establishment party led by former comedian Beppe Grillo, but we would disagree. Flirting with disaster tends to focus minds, and it is likely that some of those who voted for Mr Grillo will be put off, rather than motivated by, his strong showing – just as Greek voters went sour on Syriza following their surprise strength in elections last year.
Nevertheless, investors are rightly concerned about the political situation and have shunned Italian debt, pushing the yield on ten-year government bonds up 50 basis points on Tuesday – the second largest daily rise since the introduction of the euro. The FTSE MIB fell by 4.9%. Meanwhile the euro also suffered, falling to its lowest level against the dollar since the start of this year as doubts about the currency’s long-term viability resurfaced.
Over the past month, the market-implied probability of a default by Italy on its $2.2 trillion of sovereign debt has risen from 21% to 25%, while the market-implied probability of Italy leaving the single currency bloc has risen from 4% to 11%. While this is still some way off its high, reached in the summer last year, the direction of travel is concerning.
Events of this week demonstrate that the OMT programme is not quite the effective backstop that many had hoped for. One of the programme’s flaws, as we highlighted when it was first unveiled, is that ECB purchases are dependent on the country in question signing up to structural reforms and fiscal consolidation. It remains unclear how policymakers in Frankfurt would react to a spike in Italian yields, stemming from fears that a new government, albeit a democratically elected one, would renege on the austerity plans of Mario Monti. Under that scenario, the OMT may be found wanting, just when it is most needed.
Monday’s vote was effectively a vote against European policymakers’ current prescription of severe fiscal consolidation, in a fixed currency zone, with little or no monetary offset. This has, as we warned it would, led to prolonged recessions with no end yet in sight. Southern Europe’s citizenship is unlikely to accept these policies indefinitely, especially with youth unemployment rising ever higher. With that in mind, the biggest risk of exodus may come from peripheral voters, not international bond markets – something that neither the ECB nor German politicians have much control over.