Italy’s election was a mess, with a hung parliament projected and populist eurosceptic parties possibly taking power. Expect news media to keep focusing on the blurry picture for a while longer, and while it will continue to roil European markets (the iShares Italy ETF (EWI, Financial) is down over 2% today), it’s nothing compared to what could happen in September. That’s when the European Central Bank is scheduled to stop its bond-buying programs.
The results of the elections are being compared to the rise of President Donald Trump in the U.S. There are similarities, but financially speaking, there isn’t much difference between nationalist populists and the mainstream establishment, in any country. Both sides are big spenders and borrowers, which is fine so long as the respective central banks keep financing it all with newly printed money. In Italy’s case, even if a new government in Italy can be formed and it wants to leave the euro – a very far-fetched supposition given that leaving the single currency would cause massive market dislocations that voters would not appreciate – it would not be able to.
Why not? When the ECB bond-buying program peters out by September, the incredibly distorted Italian yield curve could get a quick dose of reality and may send Italian short-term interest rates soaring
A quick look at the Italian yield curve below shows that interest rates in Europe’s most indebted sovereign are negative out to two years. That means Italian debt investors are paying Italy for the privilege of loaning it money for as long as two years -- this for a country that has a debt-to-GDP ratio of 132%.
What does this mean practically? It means that as of now, the Italian government can keep issuing short-term debt up to a two-year maturation and be paid to do it. This is how Italy can keep its debt under control in the short term without any significant spending cuts, since it earns money for issuing debt. Who wouldn’t issue debt under such circumstances? The minute rates turn positive on the short end, though, and things could change quickly.
Obviously, a negative interest rate on any yield is not a thing that makes logical sense. It is only this way because the ECB has a policy to keep buying bonds whatever the price. It doesn’t care if it has to pay the Italian government for holding its debt. Once the ECB stops buying Italian bonds, you’re left with investors who actually want returns for their capital, investors who can't print their own money. That means that negative interest rates at the short end of the Italian curve could quickly turn positive, and Italy’s debt will start to climb again.
Therefore, any new populist government in Italy, even a bona fide eurosceptic administration, may issue a lot of words about the dangers of the single currency and how it dampens Italian sovereignty, but without strong finances, no populist government will be able to implement any of its policies. Beggars can’t be choosers, as the saying goes.
Sharp words could continue to eat into Italian equities nonetheless, and analysts will continue to make a big fuss about how a new populist government could affect stocks. But it’s really just a side show. The main event for Italian markets continues to be the tapering and cessation of the ECB bond buying program scheduled for September.
Disclosure: No positions.
