Two days ago, when looking at the ongoing turmoil gripping the Italian market, where the imminent formation of a populist, Euroskeptic government with a penchant for spending and threatening to impose a "parallel currency", the "Mini-BoT" has sent Italian yields soaring to the highest level in years, we noted something more troubling not just for Italy, but for all of Europe: Italy's redenomination risk was soaring, and was starting to spread to the other key PIIGS: Portugal and Spain (Greece, having recently concluded its 4th bailout will probably not implode soon).
Still so far the contagion has been quite limited, with "redenomination risk" barely rising to levels seen at the start of the year. Furthermore, today the (long-overdue) hurricane that hit Italy's market over the past two weeks seemed to abate in early trading, pushing BTPs modestly higher and bunds lower, after local press reported that 5-Star was considering Luidi Zingales for Finance Minister, a far more mainstream candidate than the euroskeptic Paolo Savona who is currently the top candidate for the post.
However, the early bund weakness and peripheral gains were quickly reversed after reports that Paolo Savona, who has repeatedly called on the Italy government to plan for a possible euro exit, was in fact backed by League leader Salvini to become economy minister. As a result, Italian 10Ys, i.e. BTPs, which were tighter to bunds by 13bps early on Thursday, moved back to the widest levels of 2018, with the spread blowing out to 193bps...
... while the 10-year yield broke above the closely watched 2.40% resistance level.
But while some modest "contagious" spillover was already noted, much of Europe remained calm despite today's renewed late-day selling in Italy.
So when does it get serious, or in other words, what is the trigger for acute and broad contagion from the ongoing Italian political chaos?
For the answer we go to Goldman, whose X-asset strategist Francesco Garzarelli published a report this morning in which he notes that after an eerie period of complacency, markets "appear to be extremely sensitive" all of a suden to any suggestion that Italy could threaten to leave the Euro area (which would cause systemic turmoil) in order to extract greater concessions from its European partners or, in a worse-case scenario, introduce a dual currency to pursue its domestic policy ambitions.
Confirming what we already know, Garzarelli then notes that concerns about a "parallel currency" exploded after their made their way into a draft of the political agreement leaked by the press on May 16. "This marked a watershed, as the 10-year spread to Germany at that time was still close to 130bp."
It is against this backdrop that the choice of the next Minister of Finance - whether euroskeptic Paolo Savona or someone else - in the coming days will be particularly sensitive. And here Goldman notes that "for the risk premium on Italian sovereign bonds to stabilize, investors will at least need to be reassured that the seat will be occupied by someone who believes that Italy’s prosperity lies unambiguously within the single currency area." In other words, if the 5-Star/League coalition does stick with Savona, all bets are off.
It's at that point that contagion emerges as a credible threat to the rest of the Eurozone, potentially reigniting the sovereign debt crisis as some dramatically recall from those days in September-November 2011.
But at what levels? The answer to that key question brings us to the punchline of Goldman's report, which notes the following in terms of actual prices:
Tactically, we would be neutral on 10-year BTPs with spreads n in the 175-200bp area. If the anti-Euro rhetoric subsides and the Ministry of Finance is offered to an individual with a moderate stance and relevant background, which is our base case, spreads could come back to the 150-160bp range, as levered short positions are closed. Should, instead, the profile of the Cabinet profile and statements by its members continue to send conflicting signals around Italy’s Euro participation, we could see the 10-year BTP-Bund spread reaching 250bp, pushing the yield on 10-year BTPs towards 3%. Probability-weighting these two outcomes, we come out as tactically neutral at this stage.
That's the baseline scenario: what about the worst case? For the answer look at the BTP-Bund spread and specifically whether it moves beyond 200 bps, or just 7 wide of where it is trading now.
Should spreads convincingly move above 200bp, systemic spill-overs into EMU assets and beyond would likely increase. Italian sovereign risk has stayed for the most part local so far. Indeed, the 10-year German Bund has failed to break below 50bp, and Spanish bonds have increased a meager 10bp from their lows. This is consistent with our long-standing expectation that Italy would not become a systemic event. That said, should BTP 10-year spreads head above 200bp, the spill-over effects onto other EMU sovereigns would likely intensify.
The chart below shows the current level of the spread, and how close Goldman's "contagion trigger" is located.
And now that we know "what" the trigger is, here is the answer to "where" contagion would spillover to next:
The most vulnerable market in this scenario – based on historical patterns – would be Portugal. We estimate that its sensitivity to swings in our EMU-wide stress variable is twice as high as Spain’s.
Goldman then makes two follow up observations: the first is that as risk persists, the BTP-Bund correlation is likely to remain negative:
The daily correlation between BTPs and Bunds has turned negative, reflecting the Italian political uncertainty (Exhibit 3). We would expect this correlation to fall further into negative territory in two opposite scenarios: (i) a further escalation of political tensions and spill-over effects into other EMU spreads (with BTPs selling off and Bunds rallying) or (ii) an easing of political tensions, triggering a market friendly reaction on Italian rates (with BTPs rallying and Bunds selling off). We observed a similar dynamic after the first round of the French Presidential elections, when markets ruled out the possibility of Ms. Le Pen reaching the second round. In that occasion, the correlation between Bunds and OATs fell dramatically into negative territory as spreads tightened. That said, Italian political uncertainty is likely to linger for longer than was the case in France. We expect this to be reflected in more sustained volatility of Italian bond returns, and this is the reason why we expect spreads to trade above their macro ‘fair’ levels.
But the real question is at what point does Italian risk - and contagion - lead to economic weakness (or collapse) and forces the ECB to not only halt its tightening plans and undo its tapering intentions, but forces Draghi to engage in even more QE which, as a result of a continentwide bond shortage, will mean the ECB now has to buy ETFs (and single stocks) outright:
The potential for spread contagion can put further pressure on the Euro outlook. The majority of the EUR slide over the past month reflects other factors, including a softening of the Euro area’s growth momentum, and should be couched in the context of broad Dollar strength. Yet, judging for example by the behaviour of EUR/CHF, Italian risk has played a more central role in setting the tone for the currency, especially since the draft agreement was leaked by the media last week. Going forward, as long as Italian risk remains confined to the country’s borders, our FX team does not see much additional Italy-related downside risk to EUR. However, should this become a more systemic event, then we would expect to see it weigh on the currency, which would be primarily visible in EUR/CHF and secondarily EUR/USD.
This observation gives traders a second (and third) contagion indicator: the level of EURUSD and EURCHF:
Following the logic above, our guidepost for FX is therefore signs of wobbles in Portugal and other peripheral markets. Based on the usual sensitivities to peripheral sovereign risk premia, we estimate that EUR/USD could fall by around 5 big figures should systemic spill-overs increase. On the other hand, if things cool off, we expect that would push EUR/USD 2-3 big figures higher and move EUR/CHF back to 1.20 in short order.
Something tells us we will experience the "falling EUR" scenario long before the "push higher" case arrives.