Quitaly pressure on markets continues

Summary

Another day of Italian political drama looms on Wednesday to keep global market uncertainty and volatility on the rise.

PM designate survives the night

The twists kept coming well into Tuesday evening underscoring the low chance of a break anytime soon from market ructions. Unconfirmed local TV reports said the new PM designate Cottarelli might follow the lead of his predecessor and throw in the towel, i.e., give up trying to form a government – even just a transitional one – having just been handed a mandate by the head of state a day before. The talk fuelled panicky reactions in U.S shares, triggering a late spike in the VIX volatility index and a deepening rout in bank stocks. The surge to safety quickened, with yields on 10-year Treasurys extending their decline to 2.75% for the first time since early April.

Stock and bond bounce looks fragile

The benchmark U.S. yield was back on the 2.80% handle close to Europe’s open, but late Wall Street action all but guarantees renewed gyrations in European and U.S. debt on Wednesday, after key yields and curves reversed much of the Tuesday’s ascent and flattening respectively. By the same token, small opening gains for European stock indices and U.S. futures looked vulnerable to intraday reversals. For one thing pressures that pushed the FTSE Italia Banks index down by a fifth in just two weeks will take some time to lift whilst the political outlook remains uncertain. Italian bank shares have punched well above their weight this week as the centre of gravity for global shares. A continuing barrage of headlines and possible further downgrade warnings (after Moody’s on Tuesday) is likely to see Italy’s banks continue dragging on Europe, and consequently on Wall Street and beyond.

‘Whatever it takes’ levels

The Italian bond yield curve will be the focus of the most rapt attention in sovereign debt after the difference between 2-year and 10-year bonds returned to the 2011 levels that moved ECB president Mario Draghi to pledge he would do “whatever it takes”. The central bank is not expected to make any direct announcement yet. However, Italy’s internal yield differential, which is suggesting credit stress approaches ‘crisis’ levels, will maintain the sense of unease across European markets.

Real news as dramatic as talk

Corroborated news out of Italy is barely more reassuring for markets than rumours. Carlo Cottarelli failed to form a government from major political parties as widely expected, though he reportedly continued to finalise the caretaker cabinet that was always the plan B to see the country through to fresh elections. Some major parties demanded these elections be held immediately. The leader of one half of the failed would-be coalition government, 5-Star’s Luigi Di Maio, even signalled he would be open to renewed talks with the other half, the Northern League, in order to avoid a new poll. The possibility that a 5-Star/League coalition government could rise from the ashes is the least likely one this side of fresh elections, though polls suggest it would have a parliamentary majority. Instead, Italy seems on course for elections in September. There is a lower but not negligible probability that things implode well before then, triggering an election as early as 29^th July.

Yen bounce threatened

In meantime, the euro will face possible fresh multi-month lows across the dollar and the yen after $1.1510, the weakest in 10 months and 125.31 against the yen, an 11-month nadir. Wednesday’s spring back at the time of writing is almost certain to prove fleeting. The single currency was up some impressive looking 90 pips or so to 125.93 yen and had retaken 70-plus pips against the greenback to $1.1571. But the yen was taking back its tell-tale safety bid against the dollar after falling off a 108.10-yen spike high to as low as 108.88. The dollar had barely cracked half of its Tuesday fall.

Italy keeps the spotlight in a busy week

Ample Italian watch points will add to a rising global macroeconomic agenda on Wednesday and the week ahead. One of the most inconveniently timed sales of Italian government debt this decade will continue with tenders of up to €6bn in 5-10-year paper. Average auction yields have soared this week though demand has been fair. Any sign that bid-to-cover ratios are also deteriorating will increase the negative feedback loop into Italy’s stressed bond market and beyond. European sentiment data due this morning will need to resoundingly trounce expectations to aid current sentiment (unlikely). The payrolls curtain raiser from ADP this afternoon could also be similarly shrugged off unless well above or below the non-farm headline forecast around 190,000. The White House’s Tuesday statement that it retains the threat to impose fresh tariffs on China bears further clarification on Wednesday, whilst time is running out on the NAFTA front and regarding news of expiring steel duty exemptions. Trade concerns thus muddy the near-term outlook for the dollar further.