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Italy: Contagion risks amplified

Uncertainty in Rome has fed into global markets with signs of contagion from the Italian crisis now clearly evident. Equity markets in the US and Asia took their cue from Europe’s battering yesterday, which saw the main bourses led lower by the FTSE MIB. The Dow sank 400 points and Asian shares followed suit with losses of around 1.5% for the Nikkei and MSCI’s broad index of Asia-Pacific shares outside Japan.

Italian stocks jumped 1% on the open with bargain hunters stepping in. But this may be a bit of a bull trap and we have already seen the gains pared back sharply. The fluid situation on the ground means stock and bond markets look set to remain volatile. Investors may well prefer to sit on the sidelines until this one settles down. The euro has recovered some ground with EURUSD driving up towards 1.159 in early trade.

We are seeing clear signs of banking sector stress amid fears of damage being done to risk assets. There is also concern that the political uncertainty coincides with a period of relative economic softness, meaning investors are starting to reduce exposure to Europe more generally. Bank stocks look exposed not only because of mark-to-market losses on assets and higher costs, but as the crisis in Italian politics forces a rethink of assumptions about central bank activity.

Italian banks hold a lot of Italy’s sovereign debt (c11%) – their fortunes are totally bound up with that of the country’s debt. But French banks Credit Agricole and BNP Paribas are also highly exposed. At present the moves on BTPs are not indicative of a major flight as domestic investors are staying put. The situation is not yet as bad as Greece was. But while he EZ could have limped on with Greece, it cannot afford to lose Italy.

Looking at Italian bonds it seems that there has been a bit of an easing in the selling although it’s been a pretty wild start to trading this morning. But the extent to which bargain hunters come in – and it must be said that the yields on offer are enticing – will be limited by the political situation and risks. There is not much chance of ‘good’ news in the coming weeks; which means buyers will be hard to find and this may well see spreads inch wider, although the pace of selling should ease up after the convulsions of yesterday. It’s hard to see the yield jumping as much as it has every day – a lot of the perceived risk is now priced in, although quite how redenomination/eurozone breakup risks are being considered is hard to fathom and even harder to price in.

These risks remain low but have risen and may well rise further if the polling points to a clearer, more explicitly anti-EU mandate for the populist parties. In this scenario we could see further upward pressure on yields and spreads through June.

Should the squeeze continue, it forces the ECB and the Fed to remain more accommodative than they would perhaps like to be. The haven flight has already pushed down Treasury yields, with the 10-yr back at 2.8%, as well as expectations for the Fed to hike more this year. Despite what the FOMC members constantly say about international concerns, it would be crazy for the Fed to hike three more times this year if the EZ is in crisis mode. The rally in Treasuries seems to have wrong-footed the market which has largely been betting on yields to go up. The flatter yield curve, which is now at its flattest since 2007, was behind the selling in US banking stocks yesterday.

Money markets are already moving against a June 2019 hike and now expect it to come in October 2019 at the soonest. It also looks less than likely the ECB will use the June meeting to end stimulus, despite what board member Sabine Lautenschlaeger might have said this week. Undoubtedly with the political uncertainty greatly compounds the worsening economic situation for the ECB. That said, a weaker euro will offer some easing of financial conditions that will soothe Mario Draghi’s nerves. Whether the ECB steps in to calm bond markets is in doubt - it's hardly going to be willing to help out the populists who are railing against its rules.

Key talking points today:

PM-designate Carlo Cottarelli may not even be sworn in and that would set us on course for a snap poll in July. This would likely increase risk in the near-term though we have no idea what the outcome of the poll would be. A move to make this election a de facto referendum on the euro could spook Italian voters, however it would be unwise to bet on the centre ground holding. This is uncharted territory.

Trade wars are back on the agenda with the White House saying it will go ahead with $50bn in tariffs on China. The rekindling of trade war fears should add to the risk-off mood in the markets.

Neil Wilson | Chief Market Analyst

Finyear - Daily News

Mercredi 30 Mai 2018