By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman
News that the Greek bond buy scheme did not get sufficient takers to reach the 30 bln euro target, set the commentariat ablaze. This may prove to be a minor technicality, as Greek banks initially offered 75% of the Greek bonds, but were prepared to pitch them all if necessary to ensure EU aid is forthcoming, which is the source of their recapitalization funds.
The bigger story is the fall of the Monti technocrat government in Italy. Berlusconi’s PDL party pulled support by abstaining from economic reform votes at the end of last week. After a series of consultations with the Italian president, it appears that parliament will not be dissolved until two important pieces of legislation are approved, the 2013 budget and financial stability measures. The former is needed for obvious domestic reasons. The latter is needed to maintain credibility in EMU; assuring its partners.
As the situation was unfolding on December 7, Italian bonds fared well, with the 10-year benchmark yield dropping 5 bp. In comparison, 10-year Spanish yields fell 2 bp. On the week, the Italian yield rose 3 bp, while Spain rose 14. Italy’s 10-year generic yield is about 93 bp below Spain’s. This is at the wider end of the range seen in recent months. Recall that end of 2011, Italy was paying a 200 bp premium over Spain.
With parliament likely to have been dissolved in any event by the middle of next month to prepare for spring parliamentary elections (must be held within 70 days of the dissolution of parliament), it is not exactly clear why Berlusconi chose now to pull the plug. As in many things of this nature, the decision may have been over-determined.
There are PDL politics to consider. It was to hold a primary and Berlusconi had to make a decision whether to run or not. There are politics among the opposition to consider. The PD had just picked their leader. The old guard carried the day as the party leader Bersani turned aside a challenge by the more charismatic Renzi. Berlusconi may have seen this as an opportunity. Recall that last year when Berlusconi was pushed out, it was not because of a convincing alternative by the opposition, but because of the hostility he arose internationally. Proof of that, of course, is Monti’s technocrat government.
Berlusconi may have also been emboldened by the economic data. Unemployment continues to rise. The economy remains mired in a recession. As this Great Graphic showed Monti’s support continues to slump, and he draws little support from the sharp decline in bond yields over the past year. Berlusconi’s timing also corresponds to the new property tax that goes into effect.
S&P warned before the weekend that it would consider lowering Italy’s rating if the recession continued well into 2013. The Bloomberg consensus currently forecasts precisely that. The economy is expected to contract through Q3 13. Last week, the ECB staff cuts its 2013 euro area growth forecasts too.
The latest polls show the center-left PD with a 15 pt lead over Berlusconi’s PDL. There is also the 5-Star movement, which is the protest party, which like in other countries has emerged during the crisis. On programmatic grounds, the 5-Star shares much in common with the PDL, including a skepticism of participating in monetary union. Both 5-Star and the PDL are based on single personalities and it is not clear that all of Italy is big enough for the egos of Berlusconi and Grillo.
More worrisome for investors, is a renewed alliance between the Northern League and the PDL. The risk is that it retracts, dilutes or in other ways backtrack from the necessary, even if insufficient reforms of Monti’s government.
There are still numerous moving pieces. It is not clear whether Monti government can pass electoral reform during its waning days. It is not clear if the local elections, in which the left tends to do better, will be held before, with the national election (as the PDL wants) or afterwards. If the PD wins, it is possible Monti becomes the next President of Italy. A hung parliament could see Monti remain Prime Minister, either in a technocrat form or as a compromise candidate with a parliamentary majority.
Regardless of the particular details, the political risk in Italy has risen and Italian bonds will likely suffer as a result. It could have knock negative repercussions for the euro. With the latest turn in Italian politics, Italy may leap frog over both Greece and Spain as the source of angst for investors and policy makers.