The Italian job just got a whole lot harder

The last few days have brought back memories of old times as an old stomping ground has returned to the forefront of financial news. This has been the Italian bond market which has been since Friday morning a real life example of the trading phrase “Don’t try to catch a falling piano”, or in some cases knife. If we look at the Italian bond future it has fallen 6 points since late on Thursday from a bit above 127 to a bit above 121. For these times a 2 point a day drop in a bond market is quite a bit especially when we consider that one large holder will not be selling. That is of course the European Central Bank or ECB which as of the 21st of September had bought some 356.4 billion Euros of them. So we note as an initial point that  falls of this magnitude, which has been on average the old price limit for US Treasury Bond futures ( a 2 point move led to a temporary trading stop back in the day) can happen even in the QE era.

Putting this another way the yield on the Italian ten-year benchmark bond has risen to 3.4%. This means that if we look at the deposit rate of the ECB which is -0.4% there is quite a yield curve here. It starts early with for those who have been invested here quite a chilling thought. You see as recently as mid may the Italian two-year yield was negative ( last December it was -0.36%) whereas at the time of typing this it is 1.56%. So those long have had a disaster although of course they can hold the bond to maturity and just lose the yield. Although of course we would not be here if there were not at least the beginnings of fears over the maturity itself such as perhaps you not being paid in Euros. From @DailyFXTeam.

EUR Borghi comments on the desirability of Italy having its own currency push Italian 10-yr yields to 3.4%, highest since March, 2014

Claudio Borghi is the chief adviser to Matteo Salvini who is Deputy Prime Minister and has been upping the rhetoric himself this morning. Via Twitters translation service.

In Italy No one is drinking the threats of Juncker, which now associates our country with Greece.

Madness they call it madness

There has been plenty of this including this curious statement yesterday from Matteo Salvini.

*ITALY’S SALVINI SAYS `GENTLEMEN OF THE SPREAD’ WILL UNDERSTAND

If we bypass the obvious sexism he is referring to the yield spread between Italian bonds and the benchmark for the Euro area which is of course Germany. A part of the Euro project is that these should converge over time as economies also converge. Except we have seen quite a divergence recently as if we look at the ten-year gap this morning it reached 3% per annum, which if you held to maturity would be a tidy sum especially if this fantasy came true.

Borghi advocating an ECB enforced max spread to Germany of 150bps. ( h/t @stewhampton )

In recent times it would appear that the ECB has been the main buyer of BTPs but it as of this week has reduced again its purchases and will buy around 1.7 billion Euros only in October. As we stand it seems unlikely to fire up its QE programme just for Italy. It did buy Italian bonds back at the peak of the Euro area crisis but bond yields were more than double what they are now.

The Deficit

In the grand scheme of things the change here has been quite minor. From Reuters.

Italy new eurosceptic government proposed on Thursday a budget that increases the deficit to 2.4 percent of gross domestic product in 2019, tripling it in comparison with the plans of its predecessors.

Actually the real change has been from 1.8% of GDP as rumoured just over a week ago, as we find that 0.6% of GDP has turned out to be the straw that broke the camel’s back. Actually the real switch in my opinion is not to be found here but rather in the implications for the national debt.

Under EU law Italy should reduce its public debt rather than increase borrowing. Rome’s total debt is worth 133 percent of GDP.

Just as a reminder the Euro area limit is supposed to be 60% of GDP. Thus Italy is supposed to be reducing its ratio but we know that it has been increasing it over the credit crunch era. Should the higher bond yields last then they will put further upwards pressure on it and in some respects Italy will start to look a little like Greece.

The economy

This is the crux of the matter as the most revealing point is that the budget forecast relies on Italy growing at 1.6% or 1.7% next year. The catch for those who have not followed its economic trajectory is that it only grows at about 1% in the good years and has had a dreadful credit crunch era. Those who were cheerleaders for the “Renzinomics” of around 2014 need to eat more than one slice of humble pie as it never happened. Yesterday brought another same as it ever was signal.

Manufacturing operating conditions in Italy stagnated during September as output and new orders both fell marginally. Job creation was sustained, but at a much slower rate as signs of spare capacity persisted………September’s data also marked the first time in just over two years that the sector has failed to expand.
Manufacturing output fell in September. Although negligible, the decline in production marked a second successive monthly contraction in line with a similar development for new orders.

If we switch to the official monthly economic report it too is downbeat.

In August, both consumer confidence and the composite business indicator declined, influenced respectively by the worsening of economic expectations and the climate in manufacturing sector, which is further affected by the
decline in book orders and expectations on production.

So we see that Italy which grew by 0.5% in the first half of the year will do well to repeat that in the second half especially if we note the slowing of the Euro area money supply we looked at last Thursday.

Much better news came from the labour market.

In August 2018, 23.369 million persons were employed, +0.3% over July. Unemployed were 2.522 million,
-4.5% over the previous month……..Employment rate was 59.0%, +0.2 percentage points over the previous month, unemployment rate was 9.7%, -0.4 percentage points over July 2018 and inactivity rate was 34.5%, +0.1 points over the previous month.

Let us hope that is true as Italy badly needs some good economic news, but it has developed a habit of declaring such numbers and then revising them higher later. Also it remains a bad time to be young in Italy.

Youth unemployment rate (aged 15-24) was 31.0%, +0.2 percentage points over the previous month

Comment

The situation here is something which has been changed by some rather small developments. Why? Well it is a consequence of my “Girlfriend in a Coma” theme which I have been running for some years now. When you grow by so little in the good times you are left vulnerable to changes, and hence apparently small ones can cause trouble. This has been added to by the frankly silly rhetoric on both sides.

Added to this is the issue of the consequences of the QE era which has been a subject over the past couple of weeks. Italy tucked itself under the “Whatever it takes” umbrella of President Draghi of the ECB but has not reformed much if at all so as the umbrella gets folded up and put away it is vulnerable again. Since that speech was given in the summer of 2012 the Italian economy has grown by a bit over 2% and is still some 4-5% smaller than it was a decade ago. This is the real Girlfriend in a coma issue which has led to the problems with the banks and the national debt and has given us the Italian version of a lost decade. As the population has been growing the individual experience has been even worse than that.

The other way that Italy is different to Greece is that in Euro terms it is indeed systemic due to its much larger size.

 

 

 

 

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Where next for US monetary policy?

So much of the economic news in 2018 has related to developments in the US economy. In particular monetary policy as the world has found itself adjusting to what is called these days a “normalisation” of policy in the United States. To my mind that poses the immediate question of what is normal now? I am sure we can all agree that monetary policy has been abnormal over the past decade or so but along that path it has also begun to feel normal. People up to the age of ten will know no different and if we allow some time to be a child maybe even those at university regard what we have now as normal. After all they will have grown up in a world of low and then negative interest-rates. The media mostly copy and paste the official pronouncements that tell us it has been good for us and “saved” the economy.

I am thinking this because the US Federal Reserve last night gave a hint that it thinks something else may be the new normal.

The staff provided a briefing that summarized its analysis
of the extent to which some of the Committee’s monetary
policy tools could provide adequate policy accommodation
if, in future economic downturns, the policy
rate were again to become constrained by the effective
lower bound (ELB)

This begs various questions of which the first is simply as we have just been through the biggest trial ever of such policies surely they know them as well as they ever will? Next comes another troubling thought which is the rather odd theory that you need to raise interest-rates now so that you have room to cut them later. This is something which is not far off bizarre but seems to be believed by some. Personally I think you should raise interest-rates when you think there are good reasons for doing so as otherwise you are emulating the Grand Old Duke of York. Also there are costs to moving interest-rates so if you put them up to bring them down you have made things worse not better.

You may also note that the Zero Lower Bound or ZLB  has become the ELB with Effective replacing zero. Is there a hint here that the US would be prepared to move to negative interest-rates next time around? After all we exist in a world where in spite of the recorded recovery we still have negative interest-rates in parts of Europe and in Japan. Indeed the -0.4% deposit rate at the ECB has survived what the media have called the “Euroboom”.

Effective Lower Bound

There are some odd statements to note about all of this. For example.

Accordingly,in their view, spells at the ELB could become
more frequent and protracted than in the past, consistent
with the staff’s analysis.

Seeing as we have been there precisely once what does “more frequent” actually mean? Also considering how long we were there the concept of it being even more protracted is not a little chilling if we consider what that implies. Also this next bit is not a little breathtaking when we consider the scale of the application of the policy “toolkit”

They also emphasized that there was considerable uncertainty about the economic effects of these tools. Consistent with that view, a few participants noted that economic researchers had not yet reached a consensus about the effectiveness of unconventional policies.

I do not know about you but perhaps they might have given that a bit more thought before they expanded the Federal Reserve balance sheet to above 4 trillion dollars! As to possible consequences let me link two different parts of their analysis which would give me sleepless nights if I had implemented such policies.

A number of participants indicated that there might be significant costs associated with the use of unconventional policies……….. That decline was viewed as likely driven by various factors, including slower trend growth of the labor force and productivity as well as increased demand for safe assets.

Policy Now

This is the state of play for interest-rates.

The Committee expects that further gradual increases in the target range for the federal funds rate will be consistent with sustained expansion of economic activity,

How far? Well Robert Kaplan of the Dallas Fed gave a road map on Tuesday.

With the current fed funds rate at 1.75 to 2 percent, it would take approximately three or four more federal funds rate increases of a quarter of a percent to get into the range of this estimated neutral level.

At this stage, I believe the Federal Reserve should be gradually raising the fed funds rate until we reach this neutral level.

So circa 2.5% is the target and that seems to have been accepted by the bond market as we see the ten-year Treasury Note yield at 2.82% and the thirty-year Treasury Bond yield at 2.98%. When you read about the “yield curve” and in particular reports of it being flattish this is what they mean as we have a difference of a bit over 1% between the official interest-rate and the thirty-year bond.

There has been a lot of discussion about what this means but to my mind it simply means that the bond market has figured out where the US Federal Reserve intends to send interest-rates and has set prices in response. It will have noted the problems abroad that the interest-rate rises have contributed too and the discussions about possible future cuts and adjusted yields downwards. Whether that turns out to be right or wrong is a matter of opinion but to my mind whilst we have QT now ( the Federal Reserve balance sheet is being shrunk albeit relatively slowly) regular readers will be aware I think there are scenarios where interest-rates go up and the QE purchases begin again. Some such thoughts were perhaps on the mind of Robert Kaplan on Tuesday.

Despite the fact that the current economic expansion is the second longest in the postwar period, U.S. government debt held by the public now stands at 75.8 percent of GDP, and the present value of unfunded entitlements is estimated at approximately $54 trillion. The recent tax legislation and bipartisan budget compromise legislation are likely to exacerbate these issues. As a consequence of this level of debt, the U.S. is much less likely to have the fiscal capacity to fight the next recession.

Notice the reference to US debt held by the public which of course omits the holdings by the Fed itself.

Comment

There is a fair bit to consider here and so far I have left out two factors. The first is the Donald who has expressed a dislike for interest-rate rises but so far on a much more minor scale than say President Erdogan in Turkey. Next is the issue of the Dollar which is two-fold as in its exchange-rate and how many of them there are to go around. As to the dollar exchange rate then stormy times for the US President seem to have capped it for the short-term. But as to quantity the era of QT seems unsurprisingly to have reduced the supply around the world and therefore contributed to troubles in places which relied on there being plenty of them.

This brings us to the Jackson Hole symposium which starts today where central bankers gather to discuss what to do next. For example back in 2012 Micheal Woodford gave a speech about Forward Guidance which has now become an accepted part of the “toolkit”. Central bankers seem to inhabit a world where it is not a laughing-stock and instead is avidly received and listened to by an expectant population. This time around the official story is of “normalisation” as even the unreliable boyfriend has raised interest-rates albeit only a nervous once. Also the Swedes are again promising to reduce their negativity although that has become something of a hardy perennial.

But in the backrooms I suspect the conversation will shift to “what do we do next time?” when the next recession hits and for the market aware that may be added to by the recent price behaviour of Dr,Copper. On such a road the normalisation debate may suddenly become an Outkast.

I’m sorry, Ms. Jackson, I am for real
Never meant to make your daughter cry
I apologize a trillion times

What is driving bond yields these days?

Yesterday brought us an example of how the military dictum of the best place to hide something is to put it in full view has seeped into economics. Let me show you what I mean with this from @LiveSquawk.

HSBC Cuts German 10-Year Bond Yield Forecast To 0.40% By End-2018 From 0.75% Previously, Cites Growth Worries, German Political Tensions Among Reasons – RTRS

Apart from the obvious humour element as these forecasts come and go like tumbleweed on a windy day there is the issue of how low this is. Actually if we move from fantasy forecasts to reality we find an even lower number as the ten-year yield is in fact 0.34% as I type this. This poses an issue to me on a basic level as we have gone through a period of extreme instability and yet this yield implies exactly the reverse.

Another way of looking at this is to apply the metrics that in my past have been used to measure such matters. For example you could look at economic growth.

Economic Growth

The German economy continued to grow also at the beginning of the year, though at a slower pace……. the gross domestic product (GDP) increased 0.3% – upon price, seasonal and calendar adjustment – in the first quarter of 2018 compared with the fourth quarter of 2017. This is the 15th quarter-on-quarter growth in a row, contributing to the longest upswing phase since 1991. Last year, GDP growth rates were higher (+0.7% in the third quarter and +0.6% in the fourth quarter of 2017). ( Destatis)

If we look at the situation we see that the economy is growing so that is not the issue and furthermore it has been growing for a sustained period so that drops out as a cause too. Yes economic growth has slowed but even if you assume that for the year you get ~1.2% and it has been 2.3% over the past year. Thus if you could you would invest any funds you had in an economic growth feature which no doubt the Ivory Towers are packed with! Of course it is not so easy in the real world.

So we move on with an uncomfortable feeling and not just be cause we are abandoning and old metric. There is the issue that we may be missing something. Was the credit crunch such a shock that we have yet to recover? Putting it another way if Forbin’s Rule is right and 2% recorded growth is in fact 0% for the ordinary person things fall back towards being in line.

Inflation

Another route is to use inflation to give us a real yield. This is much more difficult in practice than theory but let us set off.

 The inflation rate in Germany as measured by the consumer price index is expected to be 2.1% in June 2018. ( Destatis)

So on a basic look we have a negative real yield of the order of -1.7% which again implies an expectation of bad news and frankly more than just a recession. Much more awkward is trying to figure out what inflation will be for the next ten years.

This assessment is also broadly reflected in the June 2018 Eurosystem staff macroeconomic projections for the euro area, which foresee annual HICP inflation at 1.7% in 2018, 2019 and 2020.  ( ECB President Draghi)

That still leaves us quite a few years short and after its poor track record who has any faith that the ECB forecast above will be correct? The credit crunch era has been unpredictable in this area too with the exception of asset prices. But barring an oil price shock or the like real yields look set to be heavily negative for some time to come. This was sort of confirmed by Peter Praet of the ECB on Tuesday although central bankers always tell us this right up to and sometimes including the point at which it is obviously ridiculous.

well-anchored, longer-term inflation expectations,

 

The sum of short-term interest-rates

In many ways this seems too good to be true as an explanation as what will short-term interest-rates be in 2024 for example? But actually maybe it is the best answer of all. If like me you believe that President Draghi has no intention at all of raising interest-rates on his watch then we are looking at a -0.4% deposit rate until the autumn of 2019 as a minimum. Here we get a drag on bond yields for the forseeable future and what if there was a recession and another cut?

QE

This has been a large player and with all the recent rumours or as they are called now “sauces” about a European Operation Twist it will continue. For newer readers this involves the ECB slowing and then stopping new purchases but maintaining the existing stock of bonds. As the stock of German Bunds is just under 492 billion Euros that is a tidy sum especially if we note that Germany has been running a fiscal surplus reducing the potential supply. But as Bunds mature the ECB will be along to roll its share of the maturity into new bonds. Whilst it is far from the only  player I do wonder if markets are happy to let it pay an inflated price for its purchases.

Exchange Rate

This is a factor that usually applies to foreign investors. They mostly buy foreign bonds because they think the exchange rate will rise and in the past the wheels were oiled by the yield from the bond. Of course the latter is a moot point in the German bond market as for quite a few years out you pay rather than receive and even ten-years out you get very little.

Another category is where investors pile into perceived safe havens and like London property the German bond market has been one of this. If you are running from a perceived calamity then security really matters and in this instance getting a piece of paper from the German Treasury can be seen as supplying that need. In an irony considering the security aspect this is rather unstable to say the least but in practice it has worked at least so far.

Comment

We find that expectations of short-term interest-rates seem to be the main and at times the only player in town. An example of this has been provided in my country the UK only 30 minutes or so ago.

Britain’s economic strength shows a need for higher interest rates, Mark Carney says. ( Bloomberg)

Mark Carney prepares ground for August interest rate hike from Bank of England with ‘confident’ economic view ( The Independent).

The problem for the unreliable boyfriend who cried wolf is that he was at this game as recently as May and has been consistently doing so since June 2014. Thus we find that with the UK Gilt future unchanged on the day that such jawboning is treated with a yawn and the ten-year yield is 1.28%. If you look at the UK inflation trajectory and performance than remains solidly in negative territory. So the view here is that even if he does do something which would be quite a change after 4 years of hot air he would be as likely to reverse it as do any more.

The theory has some success in the US as well. We have seen rises in the official interest-rate and more seem to be on the way. The intriguing part of the response is that US yields seem to be giving us a cap of around 3% for all of this. Even the reality of the Trump tax cuts and fiscal expansionism does not seem to have changed this.

Is everything based on the short-term now?

As to why this all matters well they are what drive the cost of fixed-rate mortgages and longer term business lending as well as what is costs governments to borrow.

 

 

Italy faces another bond market crisis

The situation in Italy has returned to what we now consider as a bond market danger zone although this time around the mainstream media seems much less interested in a subject which it was all over only a fortnight ago. Before we get to that as ever we will prioritise the real economy and perhaps in a type of cry for help the Italian statistics office has GDP ( Gross Domestic Product) per capita at the top of its page. This shows that the post Second World War surge was replaced by such a decline since the 28,699 Euros of 2007 that the 26,338 of last year took Italy back to 1999. The lack of any growth this century is at the root cause of the current political maelstrom as it is the opposite of what the founders of the Euro promised.

Retail Sales

These attracted my attention on release yesterday and you will quickly see why.

In April 2018, both the value and volume of retail trade show a fall respectively of -4.6% and -5.4%
comparing to April 2017, following strong growth in March 2018.

Imagine if that had been the UK Twitter would have imploded! As we look further we see that there seems to be an Italian spin on the definition of a recession.

In April 2018, the indices of retail trade saw a monthly recession, with value falling by 0.7% and volume
dropping by 0.9%.

Taking a deeper perspective calms the situation somewhat but leaves us noting a quarterly decline.

Notwithstanding the monthly volatility, looking at the underlying pattern, the 3 months to April picture
reports a slight decline as value decreased by 0.5% and volume contracted by 0.2%.

This is significant as this is supposed to be a better period for the Italian economy which has been reporting economic growth for a couple of years now. It does not have the UK problem of inflation impacting on real wages because inflation is quite subdued.

In May 2018, according to preliminary estimates, the Italian harmonised index of consumer prices (HICP) increased by 0.4% compared with April and by 1.1% with respect to May 2017 (it was +0.6% in the previous month).

Actually the rise in inflation there may further impact on retail sales via real wages. Indeed the general picture here sees retail sales in April at 98.6 compared to 2015 being 100. Seeing as that is supposed to have been a better period for the Italian economy I think it speaks for itself.

The economy overall

This is consistent with the general European theme we have been both observing and expecting. From yesterday’s official monthly report.

The downturn in the leading indicator continues, suggesting a deceleration in economic activity for the coming months.

This would continue the decline as in terms of GDP growth we have seen 0.5% twice then 0.4% twice and then 0.3% twice. Ironically that had shifted Italy up the pecking order after the 0.1% for the UK and the 0,2% for France after its downwards revision. But the detail is not optimistic.

Italian growth has been fostered by change in inventories (+0.7 percentage points) and by domestic consumption expenditures (+0.3 percentage points).

The inventory position seems to be a case of “what goes up must come down” from the aptly named Blood Sweat & Tears and we have already seen that retail sales will not be helping consumption.

The trade position is in general a strong one for Italy but the first quarter showed a weakening which seems to have continued in April.

In April, exports toward non-EU countries recorded a contraction (-0.9% compared to the previous month) less marked than in the previous months (- 3.1% over the last three months February-April). In the same quarter, total
imports excluding energy showed a negative change (-0.7%).

So lower exports are not good and lower imports may be a further sign of weakening domestic demand as well. As ever the monthly data is unreliable but as you can see below Italy’s vert strong trade position with non EU countries has weakened so far this year as we mull the stronger Euro.

The trade balance registered a surplus of 7,141 million euro compared to the surplus of 7,547 million euro in the same period of 2017.

An ominous hint of trouble ahead comes if we note the likely impact of a higher oil price on Italy’s energy trade balance deficit of 12.4 billion Euros for the first four months of 2018.

Bond Markets

These are being impacted by two main factors. Via @liukzilla we are able to award today’s prize for stating the obvious to an official at the Bank of Italy.

ROSSI SAYS YIELD SPREAD WIDER DUE TO -EXIT RISK: ANSA || brilliant…

It seems to have been a day where the Bank of Italy is indeed in crisis mode as we have also had a case of never believe anything until it is officially denied.

A GRADUAL RISE IN INTEREST RATES TO PRE-CRISIS LEVELS IS NOT A CAUSE FOR CONCERN FOR ITALY -BANK OF ITALY OFFICIAL ( @DeltaOne )

The other factor is the likelihood that the new Italian government will loosen the fiscal purse strings and spend more. It is already asking the European Union for more funds which of course will come from a budget that will ( May?) lose the net contribution from the UK.

Thus the bond market has been sold off quite substantially again this week. If we look at it in terms of the bond future ( BTP) we see that the 139 and a bit of early May has been replaced by just under 123 as I type this. Whilst there are implications for those holding such instruments such as pension funds the main consequence is that Italy seems to be now facing a future where the ten-year benchmark yields and costs a bit over 3%. This is a slow acting factor especially after a period where the ECB bond purchases under QE have made this cheap for Italy. But there has already been one issue at 3% as the new drumbeat strikes a rhythm.

There has also been considerable action in the two-year maturity. Now this is something that is ordinarily of concern to specialists like me but the sharp movements mean that something is going on and it is not good. It is only a few short week’s ago that this was negative before it then surged over 2% in a dizzying rise before dropping back to sighs of relief from the establishment. But today it is back at 1.68% as I type this. In my opinion something like a big trading position and/or a derivative has blown up here which no doubt will be presented as a surprise at some future date.

Meanwhile here is the Governor of the Bank of Italy describing the scene at the end of last month.

Having widened considerably during the sovereign debt crisis, the spread between the average cost of the debt and GDP growth narrowed to around
1 per cent. It could narrow further over the next few years so long as the economic situation remains positive. If the tensions of the last few days subside, the cost of debt will also fall, if only slightly, when the securities
that were placed at higher rates than newly issued ones come to maturity.

Comment

So to add to the other issues it looks like the Italian economy is now slowing and of course it was not growing very much in the first place. This makes me think of the banks who are of course central to this so let us return to Governor Visco’s speech.

Italian banks strengthened capital in 2017. Common equity increased by €23 billion, of which €4 billion was provided by the Government for the recapitalization of Monte dei Paschi di Siena.

Those who paid up will now be mulling losses yet again as even more good money seems to be turning bad and speaking of bad.

NPLs, net of loan loss provisions, have
diminished by about a third with respect to the end of 2015, to €135 billion. The coverage ratio, i.e. the ratio of the stock of loan loss provisions to gross NPLs, has reached 53 per cent, a much higher level than the average for the
leading European banks.

On and on this particular saga goes which will only really ever be fixed by some economic growth which of course is where we came in. Also whoever has done this has no doubt been suffering from a sleepless night or two recently.

The decrease in the stock of NPLs is partly due to the sharp rise in sales on the secondary market, facilitated by the favourable economic situation
(€35 billion in 2017 against a yearly average of €5 billion in the previous four years). This year sales are expected to reach €65 billion for the banking
system as a whole.

 

 

 

Are interest-rates on the rise now?

As we find ourselves heading into the second decade of the credit crunch era we find ourselves observing an interest-rate environment that few expected when it began. At the time the interest-rate cuts ( for example circa 4% in the UK) were considered extraordinary but the Ivory Towers would have been confident. After all they had been busy telling us that the lower bound for interest-rates was 0% and many were nearly there. Sadly for the Ivory Towers the walls then came tumbling down as Denmark, the Euro area , Sweden, Switzerland and Japan all entered the world of negative official interest-rates.

Even that was not enough for some and central banks also entered into sovereign and then other bond purchases to basically reduce the other interest-rates or yields they could find. Such QE ( Quantitative Easing) purchases reduced sovereign bond yields and debt costs which made politicians very happy especially when they like some official interest-rates went negative. When that did not work either we saw what became called credit easing where direct efforts went into reducing specific interest-rates, In the UK this was called the Funding for Lending Scheme which was supposed to reduce the cost of business lending but somehow found that  instead in the manner of the Infinite Improbability Drive in the Hitchhikers Guide to the Galaxy  it reduced mortgage interest-rates initially by around 1% when I checked them and later the Bank of England claimed that some fell by 2%.

What next?

Yesterday brought a reminder that not everywhere is like this so let me hand you over to the Reserve Bank of India.

On the basis of an assessment of the current and evolving macroeconomic situation at its
meeting today, the Monetary Policy Committee (MPC) decided to:
• increase the policy repo rate under the liquidity adjustment facility (LAF) by 25 basis
points to 6.25 per cent.
Consequently, the reverse repo rate under the LAF stands adjusted to 6.0 per cent, and the
marginal standing facility (MSF) rate and the Bank Rate to 6.50 per cent.

There are two clear differences with life in Europe and the first is a rise in interest-rates with the second being that interest-rates are at or above 6% in India. It feels like another universe rather than being on the sub-continent but it does cover some 1.3 billion people. Sometimes we over emphasise the importance of Europe. As to why it raised interest-rates the RBI feels that the economy is going well and that inflation expectations are rising as domestic inflation ( official rents) has risen as well as the oil price.

The US

This has moved away from zero interest-rates and now we face this.

to maintain the federal funds rate in a target range of
1½ to 1¾ percent

It seems set to raise interest-rates again next week by another 0.25% which has provoked Reuters to tell us this.

With inflation still tame, policymakers are aiming for a “neutral” rate that neither slows nor speeds economic growth. But estimates of neutral are imprecise, and as interest rates top inflation and enter positive “real” territory, analysts feel the Fed is at higher risk of going too far and actually crimping the recovery.

Personally I think that they do not understand real interest-rates which are forwards looking. So rather than last months print you should look forwards and if you do then there are factors which look likely to drive it higher. The most obvious is the price of crude oil which if we look at the West Texas Intermediate benchmark is at US $65 per barrel around 35% higher than a year ago. But last month housing or what the US callers shelter inflation was strong too so there seems to be upwards pressure that might make you use more like 2.5% as your inflation forecast for real interest-rates. So on that basis there is scope for several more 0.25% rises before real interest-rates become positive.

One point to make clear is that the US has two different measures of inflation you might use. I have used the one that has the widest publicity or CPI Urban ( yep if you live in the country you get ignored…) but the US Federal Reserve uses one based on Personal Consumption Expenditures or PCE. The latter does not have a fixed relationship with the former but it usually around 0.4% lower. Please do not shoot the piano player as Elton John reminded us.

If we move to bond yields the picture is a little different. The ten-year seems to have settled around 3% or so ( 2.99% as I type this) giving us an estimated cap for official interest-rates. Of course the picture is made more complex by the advent of Quantitative Tightening albeit it is so far on a relatively minor scale.

The Euro area

Here we are finding that the official line has changed as we await next week’s ECB meeting. From Reuters.

Money market investors are now pricing in a roughly 90 percent chance that the European Central Bank will raise interest rates in July 2019, following hawkish comments from the bank’s chief economist on Wednesday.

In terms of language markets are responding to this from Peter Praet yesterday.

Signals showing the convergence of inflation towards our aim have been improving, and both the underlying strength in the euro area economy and the fact that such strength is increasingly affecting wage formation supports our confidence that inflation will reach a level of below, but close to, 2% over the medium term.

For newer readers he is saying that in ECB terms nirvana is near and so it will then reduce policy accommodation which is taken to mean ending monthly QE and then after a delay raising interest-rates.

So it could be a present from Mario Draghi to his successor or of course if he fails to find the switch a job he could pass on without ever raising interest-rates in his eight years as President.

Comment

Before I give my opinion let me give you a deeper perspective on what has been in some cases all in others some of our lives.

Since 1980, long-term interest rates have declined by about 860 basis points in the United States, 790 basis points in Germany and more than 1,200 basis points in France. ( Peter Praet yesterday)

On this scale even the interest-rate rises likely in the United States seem rather small potatoes. But to answer the question in my title I am expecting them to reach 2% and probably pass it. Once we move to Europe the picture gets more complex as I note this from the speech of Peter Praet.

the underlying strength in the euro area economy

This is not what it was as we observe the 0.4% quarterly growth rate in Euro area GDP confirmed this morning or the monthly and annual fall in manufacturing orders for Germany in April. Looking ahead we know that narrow money growth has also been weakening. Thus the forecasts for an interest-rate rise next June seem to be a bit like the ones for the UK this May to me.

Looking at the UK I expect that whilst Mark Carney is Bank of England Governor we will be always expecting rises which turn out to be a mirage. Unless of course something happens to force his hand.

On a longer perspective I do think the winds of change are blowing in favour of higher interest-rates but it will take time as central bankers have really over committed the other way and are terrified of raising and then seeing an economic slow down. That would run the risk of looking like an Emperor or Empress with no clothes.

 

 

 

 

Can Mario Draghi and the ECB help Italy?

Yesterday was quite an extraordinary day especially in Italian markets. However I wish to move on to consider things from the new tower of the European Central Bank. So as we move geographically to the Grossmarkthalle in Frankfurt we would have seen concern and probably not a little panic. The phone lines would have been burning between Frankfurt and the Bank of Italy as they discussed how to respond. At first this would have been on a tactical level about the ongoing QE ( Quantitative Easing) bond buying programme but of course the higher echelons and strategy would pretty quickly have been in play. However you spin it the billion Euros or so a week of buying of Italian bonds might have lasted all of thirty minutes if that if it was spent all in one go! I do not know if the weather was the same as in London but the storms were appropriate.

There was no formal Governing Council Meeting but I am sure that President Draghi and the Executive Board would have been in contact and others would have taken an interest. Some may have had a wry smile as up to this week the main issue would have been the location of the meeting next month in Riga Latvia. There the issues would be corruption, money-laundering and in some respects the ECB trying to put itself outside the legal system. Now the question on everyone’s minds would be Italy and the political crisis triggered there and in particular the impact on debt markets

What could the ECB do?

The obvious first move concerns the QE bond buying. This is something of a new situation as it is the first case of a major bond market facing a price rout with both flow QE as in ongoing purchases and a stock of it as the ECB has bought around 342 billion Euros of Italian government bonds so far. Thus the latter would not be sold and it would have been bought mostly from those who might have done in the situation unfolding. Yet it was not enough and the ECB has tied its own hands.

What I mean by this is that in order to get its 19 constituent nations to agree to the QE plan it buys according to their Capital Key. This is the effective shareholding of each country and reflects factors such as their relative GDP and Italy is approximately 17.5% so that is what it gets. There is scope to vary this but not a lot as Mario Draghi explained in January.

 The ECB doesn’t favour certain countries over others in its PSPP purchase programme implementation. As you know, purchases are guided by the ECB’s capital key, which takes into account GDP and population. Now, focusing excessively on any particular purchase period, for example on 2017 only, could result and yield wrong interpretations. The overall stock of Eurosystem PSPP holdings is the relevant metric for any assessment of the programme and not the recent purchase flows.

Back then too much German debt was held and too little Portuguese.

These flows can differ as the design of the programme is flexible and the distribution of actual purchases often deviates from the ECB capital key.

So whilst there is flexibility there is nowhere near enough especially as the numbers would be released next Monday and everyone would see. Actually I think the flexibility was used up last Wednesday when the ECB in baseball terms stepped up to the plate and then withdrew. No doubt there were discussions about modifying the programme but I doubt they got far and the word nein would not have been needed.

Some have been suggesting the ECB could buy more but at the moment that is a non-starter. Of course we have seen such things change but persuading German and other taxpayers to potentially bankroll a new coalition government in Italy hoping to “spend spend spend” will not be easy.

Securities Markets Programme

This was used in the Euro area crisis.

About e220 billion (bn) of bonds (par
value, excluding redemptions) were acquired from 2010 to early 2012. Greece, Ireland, Portugal, Spain, and
Italy.

As described it does seem to fit the bill.

First, purchases within the SMP occurred during a severe sovereign debt crisis, when sovereign yields in several euro area countries were high, rising, and volatile.

Of course you could argue that in spite of yesterday’s surge in Italian bond yields with the ten-year around 3% as I type this that is not high compared to the 7% of the Euro area crisis. Also the programme is shown as terminated on the ECB website although 84 billion Euros of bonds are still held.

However it is worth noting because the replacement called OMTs or Outright Monetary Transactions have never been used.

Outright Monetary Transactions will be considered for future cases of EFSF/ESM macroeconomic adjustment programmes or precautionary programmes as specified above.

That is an issue because Italy is not in one and you could hardly see Mr. Sissors persuading the Italian parliament of much at all right now let alone this. That is unfortunate from the point of view of the ECB because like the SMP it operates like this.

Transactions will be focused on the shorter part of the yield curve, and in particular on sovereign bonds with a maturity of between one and three years.

This matters because there have been some extraordinary events in short dated Italain government bonds. As recently as the fifteenth of this month the two-year yield was negative reflecting the easy ECB monetary policy and the -0.4% Deposit Rate. Yesterday it rose as high as 2.8% and today it is 2%. So some extraordinary moves with t hose who bought a fortnight ago feeling rather silly I guess.

Wider Moves

The issue here for the ECB is that not only has it been tapering its QE programme but it has been hinting at its end. That makes it awkward to fire it back up. Of course should the current weaker patch for the economy persist then it might provide an excuse/reason but it is just as true that the effect on inflation from the higher oil price is pushing in the opposite direction.

Comment

The ECB finds itself between a rock and a hard place in two respects. The first is that additional bond purchases might turn out to be an own goal if the likely governing coalition returns to its proposal involving the ECB writing off 250 billion Euros of it.Next comes the issue of Greece which does not qualify for QE in spite of enormous efforts and it might reasonably ask how a fiscally expansionary government in Italy qualifies?

There could be specific efforts to help the Italian banks although of course they have received an extraordinary amount of help as it is! Most still seem to be troubled and burdened with bad and sour loans. Mario Draghi was always very keen on buying Asset Backed Securities which I always thought was a way of helping the Italian banks in particular but as we look we see a barrier.

At the time of inclusion in the securitisation, a loan should not be in dispute, default, or unlikely to pay. The borrower associated with the loan should not be deemed credit-impaired (as defined in IAS 36).

Here is my suggestion for the ECB loudspeakers from The Sweet.

Does anyone know the way, did we hear someone say
(We just haven’t got a clue what to do)
Does anyone know the way, there’s got to be a way
To blockbuster

 

Meanwhile the Euro has recovered a bit today and is above 1.16 versus the US Dollar.

 

 

The Italian bond and bank crisis of May 2018

Oh what a difference a couple of days can make, especially in Italy right now. However we can see the cause of this quite easily and have done so more than a few times in the past. Back at the end of the last century when the Euro currency concept was being prepared its supporters argued that it would bring economic convergence to its member countries. The reality for Italy has been this if we look for an individual measure of economic performance.

The convergence issue has been a disaster for Italy. Ironically it seemed to be holding station with Germany before the Euro began but since it the German locomotive has powered ahead leaving the Italian carriage in a siding. If you had set out to diverge the two economies it would have been hard to do better ( worse?) than this. Also my theme that Italy struggles in the relatively good times was at play in the early part of the century. Then it was hit hard by the credit crunch and the Euro area crisis and sadly has still not fully sorted its banking problems.

Poverty

Another way of observing the Italian economic experience has been provided in a paper from the Universities of Modena and Rome which point out another reversal.

The paper explores the changing risk of poverty for older and younger generations of Italians throughout the republican period, 1948 to the present day. We show that
poverty rates have decreased steadily for all age groups, but that youth has been left behind. The risk of poverty for children aged 0-17, relative to adults over 65, has
increased steadily over time: in 1977, children faced a risk of poverty 30 percent lower than the elderly, but by 2016 they are 5 times likelier to be poor than someone in the age
range of their grandparents.

It is easy to always look at the bad side so let us take a moment of cheer as we note that in general poverty has fallen since the second world war and mankind has stepped forwards. However the rub as Shakespeare would put it is that the times may be a-changing and the poverty we see now in Italy is concentrated in younger age groups. This reminds me of another statistic.

Youth unemployment rate (aged 15-24) was 31.7%, -0.9 percentage points over the previous month.

So as the overall unemployment rate is 11% then the youth unemployment rate must be treble that of older age groups. Which means that they have gone back to the future.

As a matter of fact, young Italians today face approximately the same risk of poverty as their equals in age in the 1970s. No economic miracle has happened for them, and none is expected.

This seems to have been a deliberate policy as we note this.

 Our analysis points to the welfare state, which offers better protection for the elderly than it does for
the young and their families………More importantly, the
elderly continued their march towards a poverty-free existence, while the youth did not.

This leads to a rather chilling statement.

Overall, in the last seven decades, Italy has become no country for young people.

Some of this is an international issue as for example the UK had the triple-lock for the basic state pension but some is specifically Italy.

National Debt

This is an issue but not in the ordinary way. This is because what can be described as the third biggest national debt in the world has not be caused by fiscal recklessness. In recent times Italy has been restrained. The problem has been the one described above which is the lack of economic growth. On such a road to nowhere even small fiscal deficits see the national debt rise in relation to economic output or GDP (Gross Domestic Product).

Perhaps the new Prime Minister will live up to his “Mr. Scissors” nickname in this area but it will be hard for a man facing a confidence vote to do much I would think.

Italian bonds

As you can imagine this has felt just like old times for me and in spite of yesterday being a glorious bank holiday at least until the evening thunderstorm I was transfixed for a while by what was happening. Two old rules of mine worked as well.

I like the idea of applying something I was taught at the LSE albeit with a personal spin as so much has found its way into the recycling bin. Nobody seems to pick it up either which means it is set fair for the future. The other is that you buy an intraday fall of more than two points. That worked as well but with the caveat that it was a case of the “quick and the dead” and you would have been stopped out today.

Moving to the state of play as I type this we see what has become a bloodbath. The Italian BTP bond future has fallen 5 points to a low of 124 and this compares to a bit over 139 as recently as the 7th of this month. Putting it another way the ten-year yield has risen from 1.76% to 3.1%. This may not seem large moves so let me explain the issue in the QE ( Quantitative Easing) era.

  1. They are bigger than you think and an example of this is the way the US Treasury Bond market used to have a trading halt after two point moves. Annoying at the time but does give a breather.
  2. In the QE era there is the view that the central bank will bail things out and that to quote Flo “the dogs days are over”
  3. This may have tempted investors to increase position size to make a profit which of course would now be in trouble.
  4. As implied volatilities fall it is tempting not only to put on derivative positions but to increase their size as human nature is particularly vulnerable at such times.

We have two clear examples of such events. One I traded through which was the LTCM crisis of the late 90s which was a case of intellectual arrogance and of course we had the travails of the VIX index earlier this year.

Whatever It Takes

The famous saying from ECB President Draghi from the summer of 2012 of course had to save the Euro as an implication but some translated it as “to save the Italian banks”. We have followed over time the multitude of issues here but as we looked at last week another problem emerged on Thursday. From @YanniKouts.

The minute the markets will realize that Italy will restructure its debt, the Italian banks and eventually the economy will collapse. Corralito.

Since then the share prices of the Italian banks have moved into yet another bear market. Our old friend Monte Paschi the world’s oldest bank is at 2.32 Euros down 5% today or 1 Euro lower than a fortnight ago. Those of a nervous disposition might like to look away now as I point out that compares to a pre credit crunch peak of more like 7700 Euros. In a way the Italian financial crisis can be summed up by Prime Minister Renzi saying it was a good investment. Oh and as Polemic Paine reminds us a past theme is in play right now.

Waiting for second round effects from all the private hands that clamoured to buy the Italian banks’ dodgy debt.

These days the role of the ECB has increased as of course it is also the banking supervisor which I think is a bit like being Liverpool’s goalkeeping coach.

Comment

There is much to consider here and let me throw in something from this morning’s data which will not help. From the ECB.

The annual growth rate of the narrower aggregate M1, which includes currency in circulation
and overnight deposits, decreased to 7.0% in April, from 7.5% in March.

Another hint of an economic slow down albeit broad money was a little better. Moving to the financial crisis this will be felt by individual Italians as they are savers and for example around 64% of Italian debt is held by domestic hands. So they are losing and whilst overseas investors are in a minority that is still some 685 billion Euros due to the size of the market. Thanks to the Bruegel group for the data. This is of course before we get to the stock market and those holding bank debt. Remember when we were told what great deals the bank debt was? Also the “protecting savers” part from President Mattarella not only goes into my financial lexicon for these times but will be part of what historians will call the Mattarella Error.

As a final though this has answered a question we have been asking for a while. What would get the Euro to fall? This has been answered as we note it has dropped to 1.15 and a bit versus the US Dollar and even the UK Pound £ has nudged a little higher to the nearly the same number.