The Canary in the Coalmine of a Stagflationary Debt Crisis?
There are a few open questions when it comes to analysing the dynamics of the differential between Italian and German bond yields. The Spread.
Question 1. Is the ECB engaging in QT, i.e. balance sheet reduction, anytime soon?
Or that's off the table for a while?
Question 2. How smooth will the transition be between Draghi and Meloni Government?
Question 3. Is there any chance to see a joint action, at the EU level, to implement strategic fiscal policies to shield consumers from raging energy prices? Or will the initiative be left to the single national governments?
Question 4. Would Italy represent just an idiosyncratic case, or it would be the canary in the coal mine, when it comes to showing the early signs of a sovereign debt crisis spreading out?
I will elaborate my thoughts on these questions in the following !
TPI & QT
Let me set this straight. I don't think the ECB will engage in balance sheet reduction, the so-called Quantitative Tightening (QT) anytime soon. There will be a time to decrease the balance sheet.
But not yet!
The ECB will focus on raising interest rates to tame inflation and will most likely hold off on QT, at least until they are done with interest rates hiking. There are two main reasons for this. First, the effects of rising interest rates are much better understood than those of QT. Secondly, it would be really hard for the ECB to explain why they are at the same time selling core government bonds and buying Italian and/or peripheral spreads with their TPI (Transmission Protection Instrument).
What about the new government?
Let's face it, the new government, most likely led by Giorgia Meloni has no margin for errors.
The market will quickly judge them on three key policy areas: the quality and composition of the Cabinet, the policy stance on Ukraine and towards the sanctions on Russia and, last but not least, fiscal discipline. We will, probably, discover very soon in which direction we are heading. The composition of the Cabinet will be very telling. I see three main scenarios and I will try to assign them a probability:
Bearish Case. The government takes the collision route with the EU on both foreign and fiscal policy. I see relatively low probability for this to happen. I would give this scenario 20% probability. Let's not forget the President Sergio Mattarella Put. First, Mattarella will have a say in the choice of selecting key ministries. On top, if what happened to Conte's government provides any forward guidance, I am convinced that Mattarella would act very quickly if things get out of hands. The government will fall, and a technical government will be formed.
Neutral Case. A mixed bag of hits and misses. There is no abrupt discontinuity to the past, but the government does not fully play ball with the rest of Europe on fiscal ad foreign policy. In that case, the market will be quick in putting pressure on the spread and the government will be forced to backtrack and reverse policy. I give this scenario 50% probability.
Bullish Case. The government will try real hard, Ringo, to play the Shepherd. To get along with European institutions, it will be crucial to get the EUR 200bn of the Next Generation EU Fund money and keep a friendly relationship with the ECB, the buyer of last resort of peripheral debt. Let's not forget that the TPI program is discretionary , and it is conditional. That's not a small detail. When the time will come, to widen fiscal deficits, to shield consumers and businesses against outrageous energy bills, it will be essential to have the Good Shepherd of the ECB protecting the spread in the valley of darkness, to freely quote Samuel Jackson in Pulp Fiction.
Energy fiscal policy.
Ay, there's the rub!
What will be the approach in designing the fiscal policies to face the energy crisis?
We have, so far, little visibility. Do we go ahead with policies chosen at national level, or Europe will manage to pull off a common solution to tackle these issues? This will be crucial for the destiny of the yield differential between peripheral and core Europe. That's because, in the case of regional solutions, there will be issuance of sovereign government bonds to cover deficits. In the case of a joint solution, instead, the probability that deficits will be actually financed by EU-bonds - as in the case of the next generation EU money - becomes very high. It is not a small detail.
Italian Debt (BTPs): the canary in the coal mine
I do not buy into the narrative that Italy will be an idiosyncratic case. Italian politics this time could be noise (like always, to be honest). Political headlines may add to volatility, but i don't think the collision with the EU will be the policy path that will be taken.
The real problem is: does Europe have a plan?
First, do they have a clear game plan on how to implement TPI, the instrument to dampen volatility in the European spread market? When it will be clear that what governments have so far allocated to tackle the energy crisis is not enough, will Europe go quickly for a common solution , or it will just engage in a blaming game? Usually, Europe finds a common ground only when there is no alternative. We are not there yet!
My base case is that we will find ourselves in an uncomfortable trading range on the spread differential between Italian and German bonds. A likely price action could be between 260bps and 190bps. This may offer room for some tactical investment opportunities, by trading the range in the spread. But given the non-marginal tail risks of a mounting sovereign debt crisis, what is the best way to manage the risk? I think there is no way around than trading the BTP-Bund spread with a stop loss mechanism. When the trade does not work and the spread goes 20bps wider than the entry point, OUT. Trade closed, and we start again with a clean book and a clear mind!
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