Italian Credit Blows Up- EURUSD Circles 1.1500

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Market Drivers May 29, 2018
BTP tumble on political worries
EURUSD at fresh yearly lows
Nikkei -0.55% Dax -1.66%
Oil $66/bbl
Gold $1304/oz.
Bitcoin $7110

Europe and Asia:
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North America:
USD Consumer Confidence 10:00

Well, it only took 8 years but the Italian financial crisis that everyone worried about in 2010 finally hit full force today as the yield on 2-year Italian bonds rose more than 100 basis points in less than 40 minutes on fears of a full-blown political crisis.

Although Italian President Mattarella appointed Carlo Cottarelli new Prime Minister thwarting plans by the populist 5 Star to form a government, Mr. Cottarelli is seen as a transitional figure by the markets with most experts expecting a new election by September that could send a more fortified populist plurality that would have a better chance of forming a government.

The populist agenda of fiscal expansion and debt renegotiation has sent shivers through Italian credit markets which fear that such policy shift will inevitably lead to Italian exit from the euro. Italy has the highest debt per GDP ratio of any country in Europe and has more than 800B worth of sovereign debt refinancing due. The recent spike in yields will make it orders of magnitude more difficult for Italy to find financing especially given the fact that just a few weeks ago short-term Italian bonds were actually trading a negative yield.

Overall, the events of the past few days have the possibility of creating a vicious cycle for the euro. With short-term yields up any aggressive fiscal expansion will now be impossible. Meanwhile, Italian banks are sitting on a massive mark to the market losses from their BTP inventory which is likely to curtail credit to the economy even further. All of this may force the ECB to reevaluate its policy of QE taper in September. The ECB remains the only real stop gap to the Italian debt dilemma, but having already nearly exhausted its capital allocation the ECB will have to change its own rules as well as expand the program if its to act as a stabilizing force in the market. Otherwise, the BTPs are likely to resume their plunge lower and will drag EURUSD down with it.

For now, the pair may find some relief ahead of the key 1.1500 level if the bond markets in Italy stabilize, but with the damage done and no meaningful resolution to the current crisis in view, any bounce in EURUSD is likely to be temporary.

Boris Schlossberg
Managing Director

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