Europe has a new problem: Italy

There are times when the headlines of world papers are filling up with words like stocks. That happened for example at the beginning of the year 2016. There are times when it’s written a lot about gold. Or oil. Or about the financial markets generally – that happened for example during the time of Brexit voting. But there is one instrument, which usually doesn’t really attract the general laic public and so it is mentioned in the non-professional media only marginally. And we are currently at the time when the economic public practically talks about nothing else. Because that something is in movement. And if the macroeconomic connections are concerned and the potential consequences, it is perhaps even more significant than if for example the stocks were in comparable movement. That something is the government bonds.

 
Their movement was enhanced by the fact that the open scissors between the American and European monetary politics became more and more emphasized in past days. While it is expected that the monetary politics in the USA get stricter in the form of suspected raising of the signal interest rates in December, in Europe the monetary politics still stays very loose (even though it is assumed that sometimes during the spring the European central bank (ECB) also gets tougher).

The result of this disunity is mainly present in the still growing prices of primarily German government bonds. But when the price of the bond is growing it means that I buy it today for a lot of money and in time at the end of its maturity I get from the state that is the debtor, only relatively small nominal value paid back. So my so-called yield to maturity is very small or in the case of German government bonds even negative (I have a loss from this investment). And the new record happened on Wednesday: the loss from having 2-year German government bond reached the so far record of -0.75 %. That all can be happening only because the German bonds are considered the safest in Europe.

But that is not the end of it. The juicy part is only coming. While the German bonds are still more and more expensive the Italian bonds are on the other hand cheaper and cheaper (or their yield to maturity is on contrary growing). Speculators are starting to fear the Italy with how is the referendum about the fate of current Italian government coming up. And when the government falls, the election models suggest that the anti-European movement Five Star Movement would win in the early election. That would, of course, be a fundamental problem for Italian public finances because Italy is able to finance its debt only thanks to the support from ECB. So the Italian bonds are considered to be riskier and riskier.

The drop of the prices of Italian bonds wouldn’t be that interesting on its own if there wasn’t the essential start-up with its German counterparts. And not only that. So-called CLI for Italy (or composite leading indicator designed so it would predict the economic crisis the best it can) started dropping year on year already. While since the year 2000 similar drop announced four out of five Italian recessions. Both the yields of Italian bonds and this “leading indicator” are suggesting upcoming recession for Italy.

It could seem that the problems of one European country aren’t significant from the global point of view; but that would be wrong. Let’s remember how hysterically the financial markets reacted to problems of much smaller Greece. Italy is not a “single country” – it is a part of Eurozone. And Eurozone is one of the three most important economic areas: USA – China – Eurozone. Hypothetical gradation of Italian problems would therefore certainly transfer for example to the prices of Czech or Slovak bonds, which will then have an impact on shareholders of mutual funds or pension funds.

The difference between the behaviour of German and Italian bonds is so prominent that ECB announced that it is intending to let more German government bonds into circulation. ECB as a part of its money pumping into the circulation bought a significant amount of European government bonds (or it bought bonds from banks and literally “forced” cash to banks for it) and those are now missing in the circulation. To such a degree that the interbank market with short-term deposits is in fear of freezing, i.e. repo operations, where the government bonds are heavily used as a form of deposit. Freezing of market would be a significant problem because then we could basically talk about a financial crisis (which is about nothing other but about freezing of the interbank market).

That’s why ECB decided to borrow again part of demanded German bonds it owns so they could be used as deposits again. This news released a little bit of steam from the pressured European bond pressure cooker, so the prices of German bonds immediately slightly dropped, either way, their yields at many maturities are still staying deeply negative.