Clarity is here in Italian coalition talks. And the markets hate what they see. So does Brussels.
Five-year Italian debt blew out over 1%, CDS spreads have moved over 20 basis points in a week. The markets are trying to scare these outsiders now in charge in Italy to soften their stances on reform and maintain a status quo which is destroying a great country and culture.
The League and Five Star Movement leaked demands for $250 billion in debt relief from the ECB. There was also a demand for developing a mechanism for countries to leave the euro, according to a, now discredited, report from Reuters.
The final proposal doesn’t have any of this inflammatory language, but don’t think the leak wasn’t part of their negotiating strategy or part of where they are ultimately going to push things.
Because the rest of the proposal is already hostile enough to Brussels (see below). And with ECB President Mario Draghi now signaling the need to consolidate European sovereign debt under its umbrella, it isn’t necessary at the moment.
Here’s Martin Armstrong’s take:
So everyone else understands what this is about, the ECB President Mario Draghi has come out and proposed interlocking the euro countries to create a “stronger” and “new vehicle” as a “crisis instrument” to save Europe. He is arguing that this should prevent countries from drifting apart in the event of severe economic shocks. Draghi has said it provides “an extra layer of stabilization” which is a code phrase for the coming bond crash. [emphasis mine]
That tells me that Draghi understands how bad things truly are and that Italian leadership knows they have the upper hand in debt negotiations.
They are prepared to push Brussels hard to get what they want. And well they should. League leader Matteo Salvini understands how ruinous the euro as administered by Germany has been for Italy and most of Europe.
So, to him, if the price for Italy to stay in the EU is to force the northern countries to accept debt consolidation and write-down then so be it.
If they won’t agree to that, then Italy’s new leadership is prepared to back to the people and say, “We tried. Screw them. Let’s walk.”
All of this says to me they sand-bagged the press and the political establishment to get to this point.
Reconciling Divisions
The coalition proposal is a mishmash of right and left policy prescriptions that will drive the IMF and Brussels mad. But, these two very different parties have to come to some agreement if they are to wrest control of Rome from the insanity of the status quo in Europe, which serves no one’s ends except the globalists which stand behind the public faces of the EU – Juncker, Merkel, Tusk, Macron, etc.
The League is a former secessionist party that served the northern regions of Veneto and Lombardy with talks of fiscal responsibility and far lower taxes. The while Five Star Movement has grown out of the hollowing out of Southern Italy’s economy and social fabric from political rot emanating from both Rome and Brussels.
One is calling for lower taxes and regulation, the other wants generous pensions and universal income. These are not easy differences to overcome. But they have, to no one’s satisfaction. That, however, is the price for such an eclectic mix of policy positions.
That said, they are clearly together on the two most important issues facing Italy’s future, immigration and Italy’s place within the EU.
Both parties want to put Italy first. And the legislative program now proposed looks to be in that vein, while not looking (at first glance) too radical. From Zerohedge’s writeup this morning:
Seeks 15% and 20% tax rates for companies and people
Seeks guaranteed minimum income for poorer Italians
Universal basic income of €780 per person per month, funded in part through EU
Seeks end to Russia sanctions
No mention of a referendum on membership of either the EU or the euro
Agreement to meet the goals of the Maastricht Treaty
No plans to ask the ECB to cancel debt
Calls for airline Alitalia to be relaunched
Seeks to scrap Fornero pension reform
Flat tax to become a dual rate with deductions
Seeks a strong contribution to EU immigration policy
Plan calls for redefining of lender Monte dei Paschi di Siena’s mission
The highlighted ones are the most important, while the markets focus on the tax changes and universal income.
Forget those. If Italy can get the EU to lift Russian sanctions, take immigration policy away from Angela Merkel and provide a blueprint for dealing with insolvent Italian banks those would be titanic wins.
These are the issues at the heart of the EU’s foundational problems – its lack of banking cohesion and anti-democratic bureaucracy.
The Soft Sell To Italeave
So, while all of this looks like they’ve caved on the most extreme positions, in effect, they have not. Italy’s budget is getting crushed by the cost of Merkel’s Migrants. Both parties obviously feel that growth can return to the Italian economy within the euro by radically lowering taxes to reprice Italian labor lower. This would put it at an advantage relative to Germany while remaining within the euro.
Then issuing a new parallel currency, the Mini-BOT, to circulate domestically to lessen the need for euros within the domestic economy and free up Italy’s budget issues with respect to its debt servicing needs.
What I’ll say about that is with yields spiking, the Mini-BOT better get off the ground soon because Italy’s debt servicing is extremely low thanks to the ECB’s negative interest rate policy (NIRP). And once the dollar begins rising here the decisions for debt relief and consolidation may be out of any one group’s hands.
Merkel’s Out of Time
The problem now is time. Donald Trump’s pressure policy on Iran and Russia is creating the kind of uncertainty no one can forecast. It is forcing a decision on European leadership to come together and declare opposition to Washington’s diktats and forge an independent identity while at the same time look to truly end the cultural divisions and distrusts which have led to this moment thanks to a lack of fiscal unanimity.
It is clear to me Italy’s new leadership understands this with the sum and substance of these policy points. It believes it can re-align Italy’s domestic policies in Italy’s favor while forcing Brussels to face the responsibility of leading Europe forward in a way which is far more equitable than in years past.
Perhaps that’s why Angela Merkel visited Russian President Vladimir Putin for a second time in two weeks after only sending representatives for the past four years. They weren’t just talking about the Iran deal.
No that meeting was all about getting Germany out from under Trump’s thumb while not incurring his wrath. Putin’s long-game of diplomatic patience was the right path from the beginning. It’s always bet to let your opponent bluff and bluster, beat their chests and make demands they can’t enforce.
Eventually those watching realize it is all just hot air. And as time passes the cost of resistance to the bully falls and the benefits of joining a new group rise. For Germany it is energy. Russian Gas and Iranian oil are necessary for Germany to maintain its competitiveness and Trump is undermining both of these with his lack of diplomacy.
Merkel’s refusal of his proposed tariff concessions to ditch the Nordstream 2 pipeline and buy more expensive LNG from Cheniere Energy was more important than people think. There’s no reason for Merkel to believe that U.S. policy under Trump or any future president won’t do an about face. Meanwhile, pipelines are practically forever.
And Merkel is savvy enough to put her ego aside over having been outmaneuvered by Putin over Ukraine and hold the line on Nordstream 2.
The Big Reversal
Merkel has an out here. And Italy just handed it to her. I’m not sure she’s smart enough to see it.
The ECB wants debt consolidation and greater control. For the EU to survive this is necessary. Germans and the rest of the northern countries don’t want to be seen bailing out the “Club Med” countries. That would be interpreted as yet another submission to Washington and New York. Merkel cannot go through horrific debt relief talks like she did with Greece in 2015. It would destroy what’s left of her political capital. If she stands tall against Trump over Iran, however, she gains a lot. The uncertainty over how Trump will react sends the euro down, pressuring the ECB to finally move on dealing with the debt.
Europeans want normalized relations with Russia and open trade, especially German industry. There are tens of billions in investments in Russia and Crimea waiting for the sanctions to end to travel to Russia, especially with such a weak Ruble, thanks to Trump’s moronic sanctions.
Only Poland and the Baltics don’t. But, they don’t matter. It only takes one finance minister to vote against extending Russian sanctions to end them. If Merkel stands up to the U.S. on Iran, it makes it easier for Italy to force Germany to stop bullying everyone into maintaining them.
Italy drops the bombshell to end the Russian sanctions in July. Merkel “reluctantly” goes along with this. Nordstream 2 worries go away. The EU and Russia form a united front against more U.S. belligerence in Ukraine.
During Monte dei Paschi debt restructuring talks Merkel and Draghi introduce new mechanisms for debt consolidation as a model for the future.
Do I think this is the most likely scenario? No. But it is one that could come to pass if Merkel reads the shifting political winds properly. If she begins thinking in Germany’s best long-term interests then some version of this is exactly what she’ll do.
And she’ll have the hated euroskeptics from Italy to thank for saving her legacy and Europe from further political and economic marginalization.
This Is The Most Important Chart To Watch On Italy
As traders arrive at their desks this morning across America, one could be forgiven for exclaiming "I love the smell of relief rallies in the morning" as Italian bond yields are lower and Italian bank stocks are not tumbling (for the first time since Five-Star and The League joined forces)...
...and US equity futures are holding gains (from yesterday's Trump Trade Truce)...
...suggest that the indestructible market mantra that "bad is good" and "buy the dip" is back.
There's just one thing...
You just have to know where to look.
As Bloomberg's Tasos Vossos notes, a gauge of euro re-denomination risk (based on the so-called 'ISDA Basis' in Italy's credit default swaps) blew out.
What's more, redenomination risks are spreading as the measure widened in Portugal, Spain, and in France to a lesser extent, according to CMAN data.
As parallel currencies and debt-cancellation become serious discussion points for an Italian government, so European break-up risk is resurging.
Simply put, the higher this chart goes, the lower the market 'values' an Italian Euro relative to say a German Euro... and thus it is measuring the risk that the European Union - so long defended by Draghi et al. as indestructible - will break up.
While the European Central Bank’s commitment to defend the irreversibility of the euro is based as much on threats as on positive pledges, financial markets understand the risks of "Italeave" even if the likelihood of the event is still judged to be low.
This can be seen in the data on credit default swaps (CDS), which offer protection in the case of an “insured event” or, in the jargon, a credit event. The widening gap in prices between different types of CDS contracts reflects the rising risk that some euro area sovereign debts may be redenominated into new, depreciating, currencies, which would probably lead to real losses for investors.
To correctly interpret the data on CDS prices, we need a quick flashback to 2012, another year of great tension for the single currency. While the center of the crisis was in Greek sovereign debt and the Spanish banking sector, institutional investors had already begun to think of how to protect themselves from the danger of the euro’s total dissolution, which might be prompted by the exit of a big country such as Italy or France.
Back then, there were no good options available. Buying CDS wouldn’t have helped because the standard contract explicitly excluded debt redenomination from the list of credit events if the issuer were a member of the G7 or an OECD investment-grade sovereign.
Two years later, new ISDA standards entered into force: contracts made since 2014 protect against euro area countries redenominating their debt into new national currencies.
Strictly speaking, it’s still possible to redenominate debt into a different currency without triggering a credit event, but this only works if the debt is switched into a reserve currency: the US dollar, the Canadian dollar, the British pound, the Japanese yen, or the Swiss franc. In all other cases, the only way to avoid the triggering of a credit event is if the switch to the new currency does not result in a loss for the investor: “no reduction in the rate or amount of interest, principal or premium payable”.
Since 2014 two types of sovereign CDS therefore coexist: the old (ISDA 2003) and the new (ISDA 2014). The latter has always traded at spreads wider than the CDS-2003, but the difference (the ISDA basis) had generally been small until: 15-25 bps for Portugal, 10-15 bps for Italy, 8-12 bps for Spain, 2-4 bps for France, and 1-2 bps for Germany.
The width of the spread between the two types of CDS - the ISDA basis - reflects both the perceived risk of redenomination risk and, in addition, the potential scope for depreciation in the event of a return to a national currency.
This year, something has changed.
And so, the chart above shows why U.S. credit investors may be right to be more concerned over a European sovereign crisis. As a reminder, the net share of investors expecting things in Europe to improve tumbled to 5% from a record 26% in March, based on Bank of America Merrill Lynch's survey for May.
Italy Went Boom A Long Time Ago (And That's The Point!)
On June 21, 2017, Italy’s Parliament approved Law #96. The new regulation altered Law #130 of 1999. Pertaining to limitations on the activities of Special Purpose Vehicles (SPV), the 2017 amendment expanded their scope. The intention was clear; SPV’s were going to be used as the primary method of cleaning up Italian banks as a conduit for the country’s mountain of bad debts and non-performing loans (NPL).
Less than a month later, the sales team at the accounting firm PwC (what used to be known as PricewaterhouseCoopers) actually and intentionally described Italy’s NPL problem as the “place to be.”
The Italian NPL market is now definitively “The Place To Be”, due to the volumes of NPL, the highest in Europe yet (€324bn of GBV at the end of 2016) and the recent trends in the Italian NPL arena. Ailing banks are going through a restructuring process, significant banks are engaged in massive NPL deleverage plans, overall the NPL management is passing through a prominent overhaul under new ECB guidelines and the NPL servicers are experiencing a deep evolution and facing consolidation manoeuvres.
Those who live in Italy, this “place to be” is only pain from the past and a great deal still left for the future. For well-capitalized individual firms loaded with spare capacity, picking through the bones of Italy’s desperate bank sector is a necessary profit opportunity. This is how it’s supposed to work, the healthy gobbling up what’s left of the profligate and, quite frankly, stupid. The only question to ask is, what took so long?
Economists fear prolonged periods of unsuitable economic conditions because in the past it has led to structural alterations nearly all of them having been unpleasant. Unemployed workers are transformed, for one example, into unemployable workers. Though economists hold monetary policy as neutral in the long run, the same can be witnessed (starting with Japan) of banks stuck in monetary uncertainty and chronic dysfunction.
At some point, they stop acting like banks and head in direct line toward zombie status. That was true for Italy almost immediately during the 2008 panic. Italian banks just stopped lending altogether; it is stunningly remarkable to witness the trend for Italian loans over the space of just about an entire decade, to see it as an almost perfect straight line recalls only the unnaturalness of it.
The first stage of zombification was straight up liquidity preferences. Italian banks didn’t stop expanding the size of their overall balance sheet, it’s more that they did so by buying as much Italian government (almost all central government) debt as they could. It wasn’t just a matter of safety in terms of perceived credit risk, the overriding problem was liquidity risk (collateral required in both repo as well as the ECB’s ever-expanding funding windows).
Draghi’s July 2012 “promise” seen in this light becomes something other than what has been described. In short, Italy’s banks jumped out of the frying pan of stupidity (bad loans revealed as really bad in 2008) and into the official fire (PIIGS, of which one or the other middle “I” standing for Italy).
By the time Italian authorities last year finally authorized the “bad bank” option, Italian banks had accumulated €200 billion of bad debts. And I’m only including those loans that have already been reported as soured, there is another ~€120 billion of NPL’s that can be easily classified as unlikely to ever be paid off.
What did Draghi’s promise actually accomplish? For one, it’s not just the zombie banks but also what those zombies did to the Italian economy. While the ECB was buying up sovereign debt (in separate episodes, the PSPP, or QE, being only the latest non-sterilized scheme) Italy’s economy did only
appear to stabilize.
PR is not nothing for central bankers, but it is ultimately useless for Italians.
Real GDP is growing again, and has been positive for fifteen consecutive quarters, just shy of four years. There was even some acceleration indicated during this latest “reflation.”
And yet, Italians opted for a radical change in their government as a result of Parliamentary elections held earlier this year. An entirely populist government has engendered almost total mainstream condemnation.
None of the mainstream commentary takes any note whatsoever of what’s really been going on in Italy. These stories are (often purposefully) stripped of the necessary economic and financial context to de-legitimize anti-establishment
opposition.
Italy’s new government, likely to be formally confirmed within the next few days, sets a perilous precedent for Brussels: it marks the first time a founding member of the EU has been led by populist, anti-EU forces.
Might not Italians have some very good reason for being upset with the EU? The political experiment was once wildly popular in Italy. The Italian economy had always been an underperformer among the rest of Europe, North and South. It enjoyed, however, some measure of sustained growth and success – but only until October 2008.
Since, the Italians have witnessed one hackneyed scheme after another, none of them - whether domestic or originating in Brussels - having so much as a measurable impact on Italy’s truly dire economic situation.
Over the past few years, they have even been subjected to constant claims of a European recovery, even a complete renaissance. And they might wonder if that’s true, why haven’t most Italians felt it?
Here's why...
The disdain only continues, however, and it is entirely unhelpful for much beyond Italy’s borders. This weekend it was announced that an obscure formerly leftist lawyer has been named Italy’s next leader (awaiting approval of Italy’s President, Sergio Mattarella). Giuseppe Conte was apparently the compromise candidate most palatable to the League (dominating the North of Italy) and M5S (South).
In Brussels, Conte’s nomination to be PM was met with puzzlement. “Nobody knows who he is and he is not even a high-profile academic,” said one EU official, noting that even Italians had been joking that the man who could be their next prime minister was less well-known than his namesake, the Chelsea FC manager Antonio Conte.
Authorities have bungled, mismanaged, and ultimately failed in their most sacred duties; responsibilities that were largely self-appointed from the moment BNP’s money market funds suspended NAV calculations on August 9, 2007.
But the media isn’t allowed to write that, how it might upset or even obliterate the technocratic dream. Monetary policy in particular is to this day described as successful if not comprehensively so. Europe is booming, even when it isn’t even close.
A novice, populist politician in charge of Europe’s third largest economy isn’t some far-fetched dystopian nightmare.The nightmare has been the last decade under the thumb of the thoroughly and irredeemably conventional. Why not try something very different, something possibly less corrupted?
What is happening in Italy is not unique nor is it really all that far in the extreme. That’s the point. You can dismiss the politics of it, but you can only do so by denying the clear economic reality. So long as this continues, and it doesn’t seem to be abating, rather intensifying in denial, it will (can?) only become more problematic.
Authored by Jeffrey Snider via Alhambra Investment Partners
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