Return of the Euro Crisis

Return of the Euro Crisis: Italy Quakes, Rest of the World Shakes and Merkel’s Empire Breaks

Europe’s many fault lines are spreading once again, bringing the endless euro crisis saga back in 3-D realism. Italy gained a new anti-establishment government last week, even as Spain elected a new Socialista government that could crack Catalonia off from the rest of Spain. All of Europe fell under Trumpian trade-war sanctions and threatened their own retaliation. And Germany’s most titanic bank got downgraded to the bottom of the junk-bond B-bin.

But do Italy’s political-economic problems even matter? Well, Italy ruptured last week, and the rest of the earth trembled, clearly showing that Italy’s fault lines have the capacity to become the epicenter of another global financial crisis.
In one week, Europe with its impossible euromess moved back into position of being the world’s chief menace. The Eurozone is a house of cards with many exits, each with their own name, as I’ve written about frequently in the past, and it’s time to pay the never-ending euro crisis some attention once again.

The Italian shakeup caused US bond prices to soar (yields to drop) in a flight of capital from European bonds, yet US stock investors took this invasion of troubles from foreign shores as good enough news to end the week on a positive note. The NASDAQ especially never looked happier, though financials feared contagion. As a result, the contrast between tech stocks and financials burst upward to its highest peak since the top of the dot-com frenzy:

S&P Tech stock reach levels comparable to the last tech crisis.

While Europe’s troubles apparently sounded like great news to US stock investors, the Italian crisis caused EU bank stocks in aggregate to take one of their largest avalanches in history, ending in a one-week cliffhanger at their lowest level in two-and-a-half years. Deutsche Bank, Germany’s titan of global finance, ended looking like the spawn twin  of the Lehman Brothers:


Deutsche Bank alone could trigger more than just a euro crisis:

In one week, Europe with its impossible euromess moved back into position of being the world’s chief menace. The Eurozone is a house of cards with many exits, each with their own name, as I’ve written about frequently in the past, and it’s time to pay the never-ending euro crisis some attention once again.


Quitaly looks like next Brexit in everlasting euro crisis


But do Italy’s political-economic problems even matter? Well, the Italian rift zone ruptured last week, and the rest of the earth trembled, clearly showing that Italy’s fault lines have the capacity to become the epicenter of another global financial crisis. While things ended well in the US, financial markets around the world fell off a cliff when Italy’s newly formed eurosceptic government’s choice of finance minister was negated by Italy’s figurative president. Who would think inner politics of a second-tier political appointee in a second-tier European economy would cause the entire globe to shake?

Even US stocks plunged that particular day with the Dow plummeting 400 points. Though they recovered later in the week, that was only after Italy’s government managed to compromise on choice of a finance minister. Asian markets saw big drops, too. Such a global reaction to a country where the average government only lasts fourteen months anyway proves contagion is still alive and well.

At the major fault line of this earth rattling event, Italian bonds immediately busted open with the 2-year yield leaping from 0.9% to 2.4% in less than a day! (Italy’s 10-year bond rate leaped up to 3.18%, even in an environment drenched with quantitative easing.) That hasn’t happened in more than thirty years. Some of that money fled to the US, shaking the yield on the US 10-year down from 2.93% to 2.77. That’s a sizable one-day thump for the US bond market, which moves slower than cooling lava. The only day in recent years that saw the US 10-year fall that much was the time Trump triumphed in the US elections.

Italy’s new premier, Giuseppe Conte, made clear in his inaugural speech this week that the new populist Italian government is setting a trajectory for radical policy changes that put another euro crisis directly in the cross hairs. Instead of European enforced austerity, Italy will jettison Europe’s 3% budget deficit rule while establishing guaranteed income for everyone, a minimum wage, and better health care. How the debt-buried nation is going to pay for that, no one knows, except that simultaneously ditching the deficit rule reveals a clear path. To wit, in the same way the US promises greater government spending with lowered taxes, Italy’s new premier promises a new flat tax. That was a big part of why Italy’s bond interest took off again this week.

I guess that is how you get to be populist … by promising voters things that cannot be done. Welcome to Euro Disney. The result is that Old Glue Factory, the US dark horse, is back in the race to the top of the heap, thanks to Italy. The gradual move in the US toward a bond bust got a quick reprieve when euro trash became US treasuries. So, Old Glue Factory bolts ahead in the backstretch.

Oh, but before you find relief in that thought (if you’re from the US), consider this oddity of Wonderland economics: Italian bond yields still remain lower than US yields. Yes, the country that is crashing has lower yields than the far more stable and sizable US because its debt is mostly purchased by the European Central Bank, which controls interest rates. That creditor relationship, however, is precisely what is now most at stake. So, how do you spell mispriced risk? E-C-B.

In a more stable global economy, the rejected confirmation of a finance minister in Italy wouldn’t have raised a single goose bump, much less chicken flesh all over China. Makes one wonder how small the trigger for collapse could eventually be. Perhaps people are a little jumpy because of how fragile the bond market is:


Fast forward to today when one of the icons of credit and distressed investing, Oaktree Capital, joined the bandwagon of fallen angel hunters, saying that the fund “expects to see a flood of troubled credits topping $1 trillion as rising interest rates overwhelm low-quality loans and bonds….” Oaktree Capital’s Chief Executive Jay Wintrob said that when the cycle turns it will be faster and larger than ever as “fallen angels” proliferate, and added ominously that “there will be a spark that lights that fire.” Picking up on last week’s warnings by Moody’s, in which the rating agency warned of a junk bond default avalancheas rates rise, Wintrob said that the supply of low-quality debt is significantly higher than prior periods, while the lack of covenant protections makes investing in shaky creditors riskier than ever. (Zero Hedge)


Italy is a spark in a global bond tinder box, but it is also a flame thrower in the European financial system’s house of paper cards because it is not as if the EU is going to accept any part of Italy’s new governmental agenda. The battle is on, especially if Italy’s election rhetoric carries through:


Slaves of the European Union? No, thanks! I can’t wait for Italy … to regain its sovereignty to defend the national interest in any way possible…. The immigration policies and economic sacrifices imposed by the European Union have been a disaster and will be rejected by the free vote of Italians…. League will always defend our fisheries and the agriculture of Italy. Enough with the European standards that slaughter our businesses and our territory! (Zero Hedge)


With Italy’s situation now the worst it has been since World War I, it looks like this will be the summer of Italy’s discontent. It’s per-capita GDP is now 8% lower than it was in 2007 when the Great Recession began, making Italy second only to Greece in terms of how deep and long the Great Recession’s impact has been. Because Greece’s and Italy’s debt burdens were the worst of the Eurozone (at 109% of GDP and 102% respectively) at the start of the Great Recession, they were positioned the worst of any of the Eurozone countries to weather the recession. (Now Italy is at 132% of GDP.)

For those reasons, one of Prime Minister Conte’s prime objectives is to cancel 250 billion euros of Italy’s debt. As with the attempted resolution of Greece’s credit collapse, this is an epic battle that will be in the news for a long time as creditors rage against the EU government and the Italian government, wrestling to find a solution that fails to solve the problem. Conte is also pushing for EU treaty revisions that include a measure that would allow European nations to exit the euro in order to regain their own monetary sovereignty.

Bear in mind, Italy’s debt remains tenable only because it exists in an environment of extraordinarily low interest created by the ECB, given that Draghi has not yet begun the ECB’s unwind. But wait! The ECB has essentially been the only buyer of Italian bonds for the last couple of years. That makes the ECB the counterparty to any bankruptcy action by Italy’s government that would try to write down debt. The central banksters will have to scrape a little caviar back off their biscuits if they’re going to resolve this, and it is not at all clear why eurocentric kings would feel friendly toward such eurosceptic paupers. I can’t imagine them washing that dry gulp down with Dom Pérignon.


The European Central Bank stepped back from saving Italy


It would appear that the ECB decided to punish Italy for electing a non-globalist, eurosceptic government because it backed sharply away from buying Italian bonds right at the moment of their greatest need:


Laura Castelli, another Five Star parliamentarian … said in an interview with Huffington Post that “the ECB and Italian banks have slowed up if not suspended their buying of [Italian government bonds] . . . which is adding to pressure on spreads”. She also argued that “quantitative easing is being weakened at exactly the moment when we need it strengthened to secure the stability of the EU.” As it turns out, skeptical Italians [were] proven right because as the ECB revealed when it disclosed its … bond purchases for the month of May … the central bank sharply scaled back the proportion of Italian purchases relative to all other bonds … in the month of May. (Zero Hedge)

David Haggith

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