Sell Italy, buy the euro

The takes are flowing in, now that investors have started to pay attention the aspirations and policies of an Italian government of all the populists.

The difference between borrowing costs on on German and Italian debt has been on the up, for instance:

Chart from Credits Suisse, whose investment strategists are optimistic for the European single currency:

Despite the lower yield, the USD rose to a five-month high, helped by a weak EUR, which fell to 1.1770. This was driven by political instability in Italy, with the 10-year Italian bonds slumping again amid uncertainty over the Five Star MovementLeague coalition’s policy platform. Populist policy concerns also pushed Italian stocks 1.5 per cent lower. We still see the recent USD gains as temporary, reflecting excessive short positioning, and believe a revival in Eurozone economic momentum will eventually support a higher EUR.

It's a view which appears to fit any deterioration in Italian government finances into non-existential outcomes for the euro, and one which appears popular.

For instance, Stephen Gallo of BMO argues pundits aren't paying enough attention to the current account surplus for the Eurozone. The currency strategist writes:

The Eurozone's current account balance tends to be overlooked by the FX market but some attention is warranted. On a SA basis, the surplus stood at EUR32 billion in March after EUR36.8 billion in February. But if you thought this was an indication of a downward sloping profile for the series you'd be wrong. On a rolling 12M basis, the surplus was at EUR410 billion in March (highest on record). That’s approximately 4% of 2018 (estimated) Eurozone GDP, which is also the highest on record.

The chart certainly looks steep:

On the don't worry about Italy too much front, there is also Goldman Sach's interest rate strategist Francesco Garzarelli:

Gyrations in Italy won't affect EMU systemic risk much. Tactically, there is too much policy uncertainty to fade the BTP weakness. Although our view is that these events won't happen, investors are extremely sensitive to anything even remotely questioning the EU governance, let alone Euro participation. Consider that the 'fair' spread to Bunds is around 120bp, and probably rising, and a 2-sigma event would take it back to 175-200bp.

Sadly, the Italian private economy looks so much better - Italy was setting up to be the 'comeback trade' of 2018...

Citi also note foreigner's holdings of Italian sovereign debt (BTPs) is at a 20-year low, at less than a quarter of that outstanding. The Eurosystem central banks also own 23 per cent as a result of quantitative easing, so it could limit “ the impact of risk-off episodes on the cost of funding”, ie. bond yields rising sharply as investors evacuate the market.

Still, there is plenty in the programme of a populist government which could spook markets that some might feel haven't been playing too close attention to the details. John Dizard, for instance, has already highlighted the dangers of “mini-BoTs”, novel cash-like securities which could destroy the single currency if introduced on a large scale.

There is also the spending impulse, which may require throwing out large numbers in order to pass smaller ones. Here's Lorenzo Codogno of LC Macro Advisors on the spending side of things, with our emphasis:

Although there is notable lack of precise figures and no timetable for the introduction of the flat tax, independent estimates put it at 50bn, i.e. 3% of GDP, per annum. Citizenship income could be at least 17bn (their original estimate), but it may well go beyond that. The cancellation of VAT hikes accounts for 12bn. The financing of the retirement provisions would call for 5bn, according to the estimates included in the previous version of the document (now disappeared). Elimination of some taxation on petrol would cost about 5-6bn. Extra investment accounts for 6bn. Just with these few items, we approach 100bn (6% of GDP). Therefore, it is not even worthwhile to go into the details of these proposals, as they are simply unfeasible. If someone expected these two parties’ plans to move back to earth eventually, would have to think again. As the League’s governor of Lombardy said, “ If we start soft, we will end up like the past government”.

Which fits with what seems to be the prevailing view of “policy uncertainty”. Markets don't know what is coming, but at the same time don't seem to think it can be too far from the status quo.