Phoney peace for Ital­ian debt mar­kets

The Pak Banker - - OPINION - Ralph Atkins

IF held a year ago, Italy's in­con­clu­sive elec­tions would have spelt dis­as­ter for the Eu­ro­zone and fi­nan­cial mar­kets. Stale­mate in Rome, vot­ers' re­jec­tion of fis­cal aus­ter­ity and the whiff of anti-euro fer­ment in the Eu­ro­zone coun­try with the sec­ond high­est pub­lic debt level (af­ter Greece) would have jolted bonds and eq­ui­ties glob­ally. A week af­ter the re­sults, how­ever, the mar­ket re­ac­tion is dis­ap­point­ing those bears who ar­gue the world is on the brink of the next cri­sis.

True, elec­tion night saw a ner­vous cross-as­set sell-off in New York, and Ital­ian shares are still down al­most 4 per cent. But Ital­ian 10-year bond yields traded on Tues­day be­low 4.8 per cent, up just 30 ba­sis points from be­fore polling day and far be­low low last year's peak of al­most 7 per cent.

Euro­pean eq­ui­ties have re­versed losses; the FTSE Eurofirst 300 share in­dex is up 1 per cent and at its high­est since early 2011. Global at­ten­tion has switched back to the US - although deep bud­get cuts trig­gered late last week by Washington's po­lit­i­cal im­passe have not had much im­pact on in­vestor sen­ti­ment ei­ther.

Is all this a sign that mar­kets are be­com­ing less stressed, less be­witched by the "risk on, risk off" herd men­tal­ity of the past few years - or a sign of dan­ger­ous com­pla­cency?

In Italy's case, there are tech­ni­cal, coun­ter­vail­ing forces sup­port­ing the bond mar­ket. With Ital­ian debt of­fer­ing at­trac­tive yields and im­por­tant in many in­dices, a big­ger set­back would be needed to trig­ger a rush for the door. Bar­clays es­ti­mates net sup­ply at just 30 bil­lion eu­ros this year - so the choice for in­vestors will be whether to roll over ex­ist­ing debt, rather than to in­crease ex­po­sure.

Iron­i­cally, Italy may ben­e­fit from the Eu­ro­zone's frag­men­ta­tion, by which cap­i­tal has re­treated be­hind na­tional bor­ders. Domestic and Euro­pean Cen­tral Bank hold­ings of Ital­ian debt have in­creased to more than 65 per cent, from 50 per cent in mid-2011, re­duc­ing the dan­gers of cap­i­tal flight. As yields headed to­wards 5 per cent, the risk for Ital­ian banks was of miss­ing a buy­ing op­por­tu­nity: where else could they put their money to get such re­turns?

For­eign in­vestors, any­way, have given Italy the ben­e­fit of doubt. While Italy could be yet tar­geted by hedge fund shorts, Lon­don-based in­vest­ment strate­gists point to progress made by Mario Monti, the tech­no­crat prime min­is­ter ap­pointed in Novem­ber 2011, in turn­ing the coun­try around. Italy is ex­pected to run a pri­mary fis­cal sur­plus (be­fore in­ter­est pay­ments) of more than 3 per cent of gross domestic prod­uct this year, while France still runs a deficit. Italy does not have the bank­ing prob­lems of Spain, nor its re­gional ten­sions.

Of course, Italy faces huge prob­lems gen­er­at­ing eco­nomic growth and im­prov­ing com­pet­i­tive­ness, but the cri­sis is not im­me­di­ate - so no need to panic just yet. A re­bel­lious, op­ti­mistic view is that Beppe Grillo's anti-es­tab­lish­ment Five Star Move­ment might shake-up Italy's dis­cred­ited po­lit­i­cal sys­tem.

An­other, rather cir­cu­lar, ar­gu­ment is that no mat­ter how great the re­sis­tance from vot­ers, pres­sure for re­forms will re­main be­cause oth­er­wise there will be a mar­ket sell-off.

But the big­gest dif­fer­ence com­pared with a year ago is that Mario Draghi, ECB pres­i­dent, has re­moved the "tail risk" of a Eu­ro­zone blow-up.

His "out­right mon­e­tary trans­ac­tions" pro­gramme, by which the ECB could buy dis­tressed Eu­ro­zone coun­tries' bonds, re­quires an ex­ter­nally ap­proved re­form pro­gramme. Some com­men­ta­tors ar­gue that makes it ir­rel­e­vant in Italy's case - it may be months be­fore Rome has a government ca­pa­ble of sign­ing an agree­ment. But the con­sen­sus mar­ket view so far is that in a full-blown cri­sis, an ad­min­is­tra­tion would be formed.

Around the world, con­fi­dence in the heal­ing pow­ers of cen­tral bankers re­mains in­tact. In the past week, Ja­pan's share rally was ex­tended on the ex­pec­ta­tion of more ag­gres­sive mon­e­tary poli­cies af­ter the nom­i­na­tion of Haruhiko Kuroda as Bank of Ja­pan gov­er­nor; Ben Ber­nanke, US Fed­eral Re­serve chair­man, has re­as­sured that US quan­ti­ta­tive eas­ing will re­main firmly in place; and ex­pec­ta­tions have grown that the ECB will cut in­ter­est rates fur­ther to boost Eu­ro­zone growth, although ac­tion this week still seems un­likely. Against that back­drop, a sin­gle Ital­ian elec­tion or the lat­est US fis­cal twist are small parts of the story. It will take years if not decades for debt bur­dens to re­turn to lev­els en­vis­aged by the ar­chi­tects of Europe's mon­e­tary union. "You can't go straight to fully pric­ing-in 'tail risks' ev­ery time there is an elec­tion," says Lau­rence Mutkin, head of rates strate­gist at Mor­gan Stan­ley. Ital­ian politi­cians have been given time by mar­kets. But it seems a phoney peace.

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