Italy’s president may very well live to regret his decision. With his refusal to swear in the euro- and Germany-critic Paolo Savona as finance minister, he wanted to stabilise his country but has achieved the exact opposite. Markets have gone ballistic in European trading last night. The Euro is zooming in on 1.15. Italian 10-year rates topped 3.40% before settling back a little. And Bunds continued their rally as if there was no tomorrow. 10-year yields broke 20bp on the down, and 2-year yields fell below -80bp.
Risk-off is the name of the game, and again it is renewed wobbles in the eurozone that is causing it. Sergio Mattarella is on course to go down as one of Europe’s tragic figures, as in he wanted to do right by his country but served as a trigger for horrific things to come. Installing a technocrat government will probably be the biggest gamble of his political life gone awry. Rome’s parliament is unlikely to confirm it, which implies an almost certain re-run of the election after the summer.
It is equally likely that Five Stars and Lega Nord will emerge even stronger from the polls, and while they may still not have a majority they will be sufficiently legitimised to implement pretty much everything they want. Mattarella’s power will by then have been used up and the president be relegated as a vicarious agent of an emboldened populist leadership structure unless he steps down. He acted in the spirit of the European project, but he was way off the mark what his sovereign, as in the Italian people, decided.
The massive divergence between German and Italian bonds has seen their yield differential soar beyond 300bp last night, the highest level in five years and on course to eventually go back up to the 2011/12 crisis highs of 500bp, very potentially exceeding them. The spread has tripled in a month, and against such stalemate situation upon us at least through the summer, and a binary outcome to be expected post the new election, there is no reason to argue that it cannot double again.
These powerful moves basically mean one thing. Capital flight has gone rampant one more time. Italians, corporations as much as individuals, are eager to safeguard their asset base by transferring funds across the border to the perceived safety of Germany. Next month’s records of the eurosystem’s financials will present us with the dire results. Don’t be surprised to see Germany’s Target2 balance to finally increase beyond the 1 trillion Euro mark.
If anyone is shaking in their pants, it is the Germans. Next to all private loans outstanding, Germany is on the hook for a whopping 1 trillion of mostly Italy’s liabilities with the eurosystem. If Italy defaulted on its debt, or more realistically the debt was restructured, the German taxpayer will be in the forefront to lose out. I have called it the impending mother of all debt restructurings before, and Germany is likely to be forced to write off hundreds of billions of Euros in such case.
This is bad news for Angela Merkel who will eventually have to explain this little understood Target2 mechanism to her citizenry. But what is the alternative? Outright default and a consequential exit from the eurozone would be even costlier to Germany. The lifeline of the ECB’s asset purchases has worn off. Even if Mario Draghi pulled another bazooka out of his bag, a further accelerated accumulation of eurozone government bonds would be in contrast to everything the zeitgeist prescribes.
Also, such purchases in accordance with the capital key might help Italy to live another day but would almost certainly sink the entire Bund yield curve into sub-zero territory. Investors, predominantly life companies and pension funds, have already been suffering gravely from the ECB-induced market anomalies. Another bazooka would deprive them of any base to employ their funds in Euro-denominated assets. On the other hand, to break the capital key would constitute nothing but undesired debt mutualisation.
Further, the price action is likely to break the predominant market correlations that not only hedge fund positions are built on but also the majority of the financial system, such as bank balance sheets etc. Look no further than embattled Deutsche Bank. Its stock price plummeted 5% last night, tumbling below the significant threshold of 10 Euros. Considerably more weakness from here will undoubtedly raise the spectre of the Lehman days again.
Maybe Merkel has already been pre-warned. It sounded truly odd when she unexpectedly lashed out at bankers in remarks on the weekend. Why now? Why so forceful? Does she know what’s coming? If she is coerced into deciding on a bailout for Deutsche, she also needs a culprit to point the finger at. If a bailout for Germany’s largest bank coincided with the breakout of another full-blown eurozone crisis, it would clearly be a worst case scenario for the Berlin leadership.
It is understandable that periphery money is shunning their geography and deem Germany as the safe haven. On the face of it, it seems logical. However, is that really so? Germany may be the largest and strongest economy of them all on the Old Continent, but as it is tied into the eurosystem it is equally fragile to a collapse of the same.
