Italy is too big to fail, too big to bail, but euro currency investors aren’t listening

Markets may have been nervous about the prospect of a new and decidedly Eurosceptic government in Italy, comprised of a coalition of the anti-establishment Five Star party and the right-wing League, but just because that outcome, at least for now, seems less likely, there is no room for market complacency.

Italian President Sergio Mattarella may have stymied the creation of such a government by his rejection of Paulo Savona, a vocal critic of the euro and the European Union, as economy minister, but the decision has left Italy in political chaos and may even empower the Eurosceptic parties further.

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“They’ve replaced a government with a majority with one that won’t obtain one,” Five Star leader Luigi Di Maio said on Sunday, referring to Mattarella’s preferred option of seeking the establishment of a technocratic government prior to new elections. A future election may anyway be only months away.

There’s every possibility of an even stronger vote for a Eurosceptic coalition, whether that be between the League, already polling better than before, heading a centre-right alliance and imposing its agenda on its more moderate allies, or the League allying again with Five Star.

Of course, if Italy was an inconsequential economy, the prospect of formalised governmental Euroscepticism provoking political fissures between Rome and its EU partners wouldn’t be that headline-worthy.

But Italy matters. It will be the third-largest economy in the EU after Britain departs.

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That helps explain why Austrian Chancellor Sebastian Kurz hopes Italy won’t become a second Greece. Unfortunately, if Italy were to go that way it would be much worse. Italy is too big to fail but in all likelihood also too big to bail.

Under EU rules, member states are obliged to aim for a debt-to-gross domestic product ratio of below 60 per cent. Italy’s is at some 130 per cent. Its public debt amounts to 2.4 trillion euros. These are big numbers. A Five Star/League coalition would only have exacerbated the situation with both agreed on a programme of fiscal stimulus.

The ratings agency Moody’s acted on Friday to put Italy’s Baa2 debt rating, already only two notches over junk status, “on review for possible downgrade”, citing “the significant risk of a material weakening in Italy’s fiscal strength, given the fiscal plans of the new coalition government” and “the risk that the structural reform effort stalls, and that past reforms ... are reversed”.

It’s no wonder that the Italian government bond market had already taken fright. The spread between benchmark 10-year Italian and German government bonds rose above 200 basis points at one point on Friday, its widest level since June 2017. It’s worth noting that while that spread, which closed on Friday at 193.7, initially narrowed on Monday morning, it then surged well above 200. The spread had been only 110 as recently as May 2.

Yet while nerves may have been allayed somewhat, a degree of continued caution would still be understandable.

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And this is without any focus on Spain, where the future of Prime Minister Mariano Rajoy’s government is also uncertain. Last week saw Spanish 10-year government bond yields rising and their spread over equivalent German paper widening.

But it’s not just bond investors who should worry.

Data released on Friday by the US Commodity Futures Trading Commission, for the week ending May 22, showed International Monetary Market speculators short of some US$16.15 billion versus the euro. While that was a smaller exposure than the previous week, it’s still a very chunky bet on the euro when the clouds are darkening above the euro zone.

To use currency market parlance, a lot of people are still “wearing” a bad euro/US dollar position even if some will have now scaled it back or flipped it. It was notable last week that as nervousness around Italy grew, the Swiss franc, a traditional currency safe haven within Europe, gained against the euro.

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While the news from Italy did prompt a brief rally in the value of the euro versus the US dollar in Asia on Monday, the move didn’t show a lot of conviction and soon reversed. It’s hard not to conclude that there’s still a very large and stale long euro position overhanging the currency market just waiting to offload on any bounce in the value of the single currency.

Market participants have seemed reluctant to pull the plug entirely on long euro and long Italian government bond positions but it’s much easier to sell something when someone else wants to buy than when no one does. The risks around Italy remain.

Neal Kimberley is a commentator on macroeconomics and financial markets