THE GLOBAL RISKS OF ITALIAN POPULISM

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• The rapid selloff in Italian bonds reflects more than the usual anxiety associated with the political theater in that country.
• It’s taken about two week’s time for the yield on the Italian 2-year bond to get back three and half years of declines, rising from -.27% on Friday May 11th to +2.53%, the highest since September 2012.
• Italy’s President has drawn the line at the new government’s naming a Eurosceptic as the finance minister.
• French Finance Minister: “If the new government takes the risk of not respecting its commitments on debt, the deficit and the cleanup of the banks, the financial stability of the entire euro zone will be threatened.”
• A debt to GDP ratio of 130% with the 4th largest bond market in the world is not a good backdrop for the proposals of a ‘universal income’, a reduction in the retirement age and a lowered income tax to a flat rate of 15%. 

If you harbor any doubt that risk happens fast, ask an Italian. It’s taken about two week’s time for the price on the Italian 2-year bond to give back three years of gains, or in the upside-down world of bonds, three years of yield declines in just 11 trading days. 

The rapid selloff in Italian bonds reflects more than the usual anxiety associated with the political theater in that country. It’s safe to say few outside Italy have ever even heard of Giuseppe Conte, the briefly-named Prime Minister who would have led the 65thgovernment since the end of the Second World War. He is a law professor, not a politician, and was meant to be installed as a figurehead in lieu of the two leaders of the elected parties, neither of whom wanted to be second-in-command to the other and both of whom would have been too controversial to take the helm of the government.

It would seem these worst laid plans also fell through as Italy’s President drew the line at the new government’s naming a Eurosceptic as the finance minister. 

The bond market has wasted no time concluding that it was no fluke that voters have strongly backed the first populist agenda since the euro was established as the bloc’s currency in 1999. Investors have questioned whether Italy’s president is effectively forcing voters to decide to abandon the euro in favor of the lire in fresh elections. 

Consider the perspective of the sideswiped investor who hoped to buy into an Italian 2-year at a yield of -0.27%, where it was May 11th, in order to then flip it to a less suspecting investor at an even deeper negative yield for a profit. Good luck on that count given, as you can see, the yield has backed up to a positive 2.53%.

Risk Happens Fast

The carnage has not been limited to short maturity bonds. The Italian benchmark 10-year has risen 80 basis points (bps), or hundredths of a percentage point, in 11 trading days; it’s perched at 3.06%, just 10 bps shy of the highest since August 2014.

Italy’s global peers are less than impressed with the clear populist shift. In reaction to the recent elections, the French Finance Minister said, “If the new government takes the risk of not respecting its commitments on debt, the deficit and the cleanup of the banks, the financial stability of the entire euro zone will be threatened.”

The real elephant in the room is that the Italian drama is taking place against a backdrop of the global bond market’s laser focus on the European Central Bank’s (ECB) ending the very same bond market purchases that have allowed the Italians the leeway to think they can make demands.

The ECB has stated it plans to phase out its Quantitative Easing program by this September, or December at the latest. This first step is critical to then beginning to ease the euro zone off its dependency on negative interest rates.

One must stop and ask if the Italians comprehend they will be harmed the most by the medicine of ultra-easy monetary policy being removed.  The German Foreign Minister, for one, believes they will wake up to their reality before doing anything rash. As he predicts, “There will be a stable, pro-European government in Italy soon.” Famous last words or prescience in a bold statement. We will soon enough know.

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