All Crisis Scenarios Lead to Rome as ECB Starts Raising Rates
2022.07.14 09:14
All Crisis Scenarios Lead to Rome as ECB Starts Raising Rates
(Bloomberg) — A financial-market crisis focused on Italy might augur the worst turmoil in the history of the euro.
Just as German policy makers feared and soothsaying economists prophesied at the birth of the currency more than two decades ago, the weakness and indebtedness of the euro area’s third-largest economy risks becoming everyone else’s problem.
The need for a new political settlement to fix that fault is starting to become pressing, but in the meantime the onus is on European Central Bank President Christine Lagarde to craft a short-term solution.
Such muddling through, which kept the currency bloc intact when smaller Greece blew up, remains the default outcome.
Other scenarios are proliferating however. Three paths to Italian turmoil envisaged by Bloomberg Economics encompass an underwhelming ECB response, too many interest-rate hikes for its public finances to stomach, and a tumultuous political crisis.
Evidence of Italy’s vulnerability emerged just last month as the prospect of higher borrowing costs forced the yield on its 10-year debt above 4% for the first time since 2014. According to Eric Lonergan, a portfolio manager at M&G, selling its bonds was becoming a “one-way bet.”
Yields have since fallen back with the ECB’s pledge to create a backstop, but the strain is showing at the only global monetary authority that can’t raise borrowing costs without devising a tool to contain the fallout of its own policy. As investors bet on US rates rising further, the euro has hit parity with the dollar for the first time since 2002.
An ECB crisis measure likely to rely on the power of bluff is already encountering German frictions, potentially blunting its potency.
“This exercise is not going to be at all easy,” said Charles Goodhart, a former Bank of England policy maker who warned of the dangers before the euro’s birth in 1999. “The situation for the ECB is more difficult now than it virtually ever has been.”
To put that in context, its ordeal supersedes an initial devaluation of the euro after its birth in 1999, the global financial crisis of 2008, sovereign-debt turmoil focused on Greece, and panic over Italy when the pandemic struck in 2020.
Here are three ways the region might be heading for a denouement in coming months and years that would draw European Union governments into finally confronting their Italian problem.
Turmoil Tool
Lagarde persuaded colleagues to back a solution involving a two-pronged approach, after she chaired an emergency meeting from the basement of a London hotel.
Firstly, the ECB is using flexible reinvestments of pandemic-related bond purchases to keep speculators at bay. A more powerful tool will then be unveiled, probably along with its first rate hike in over a decade on July 21.
Bundesbank President Joachim Nagel wants waterproof conditions to avoid the central bank financing governments. In tandem with the possibility of a German legal challenge, such pressures could curtail the ECB’s ambitions.
“If markets believe that discord on the Governing Council is insurmountable, spreads could climb to the point that a political intervention is necessary,” Jamie Rush, Maeva Cousin and David Powell of Bloomberg Economics said in a report. “That may only be forthcoming in the depths of a crisis.”
Their first scenario is of a measure that underwhelms because of the constraints governing it. That might be because the bond-buying firepower the ECB deploys is too limited, because strings attached would be too onerous for a benefiting government to agree to, or because the detail is too vague.
Inflation Shock
The ECB has yet to even start raising rates, while the Federal Reserve and other central banks are tightening drastically.
The justification for delay is that euro zone inflation is mainly imported, while domestic demand is still contained. But what if pay pressures take off?
“In Europe, what you’re seeing is wage growth accelerating,” Arend Kapteyn, global head of economic research at UBS Group AG (SIX:UBSG), told Bloomberg Television. “That at the margin I think is going to make it difficult for inflation expectations to come down.”
Most forecasters don’t currently expect the ECB’s deposit rate to rise much above 1.5%, in line with market pricing for the so-called terminal rate.
Even if that were to transpire, the medium-term outlook may be more complicated — for example if rising costs of de-globalization and the green transition keep fueling inflation.
Such pressures could elevate the so-called neutral rate that central banks judge to neither stimulate nor constrict economic growth, suggesting a need for tighter monetary policy all round.
If the ECB needs to become much more aggressive about lifting rates, Italy’s borrowing costs might become harder to sustain. That’s the second Bloomberg Economics scenario. Even a push to 3% could propel Italy’s debt “onto an explosive path,” it warns.
Paul De Grauwe, an economist who once vied to become an ECB Executive Board member, is unconvinced the central bank would let that happen.
“If at some point there is a conflict between fighting inflation and maintaining stability in the euro zone, the ECB would have to choose stability,” he said.
Political Drama
Italy is never far from a political crisis, a state of fragility reflected in the 14 governments and 10 different premiers it has had since the creation of the euro.
Prime Minister Mario Draghi’s coalition has managed a balancing act of keeping the economy growing out of the pandemic and reducing Italy’s mammoth debt.
While he is supposed to stay in power until spring next year, cracks are showing amid jostling for position before national elections.
The Five Star Movement led by Giuseppe Conte won’t back an aid package for businesses and households hit by surging energy prices, and Foreign Minister Luigi Di Maio has split from that group to form a new party.
Meanwhile League leader Matteo Salvini wants a higher deficit to finance energy relief, and Forza Italia Leader and former Premier Silvio Berlusconi is seeking a round of talks to see if the parties remain committed to the government.
Even without early elections, the prospect of populists taking power, or a coalition that either struggles to rule or spends money unwisely, is a real one. That’s the last Bloomberg Economics scenario.
“If the political situation turns hostile and Italy’s new government can’t agree a path forward with the European Commission, the ECB cannot realistically be expected to intervene,” the BE economists said. “Given it will still have to tackle inflation, the result would be fragmentation — and potentially a crisis.”
Confrontation with the EU is dangerous because it would limit the bloc’s scope to assist. That’s how Greece was almost forced out of the euro in 2015 under the populist government of then-premier Alexis Tsipras.
Even without a standoff, the drastic cost-cutting the EU required from the Greeks isn’t so easy in Italy.
“You can’t get blood from a stone,” said Adam Posen, president of the Peterson Institute for International Economics think tank in Washington. “They’ve been running primary surpluses, for the most part, pretty aggressively.”
Precarious Future
With an average debt maturity above seven years — far less vulnerable than Greece when sovereign turmoil struck — Italy has some resilience. Its size and role as a founding EU member also put it in a different political category.
Given that backdrop, lurching between moments of tension, with intermittent fudging, may well transpire — just as it has defined the euro’s survival until now.
Such a benign path is what Dario Perkins, managing director of global macro at TS Lombard and a former UK Treasury official, is betting on.
“For the first time in a long time, the ECB actually got ahead of the problem,” he said. “The ECB has clearly realized that it is its job in preventing these euro-type-crises. So I don’t think the outlook is nearly as bleak as it appears.”
Bond investors seem to agree, reassured — for now — by the ECB’s response. The spread between 10-year Italian bond yields and German peers has narrowed from over 240 basis points in mid-June to under 200 basis points.
“If they get this right, I think it’s profoundly important and could actually fundamentally address something that has not been looked at since the euro crisis,” said Lonergan of M&G. “It totally changes the risk properties of Italian bonds.”
But each or all scenarios above might yet materialize, perhaps driven by other threats — for example a crippling region-wide recession caused by an energy crisis if Russia cuts off gas deliveries. Such a prospect “could really imperil everything, particularly Italy,” Posen reckons.
While other countries such as Greece, Spain and Portugal are vulnerable to speculation too, it’s hard to envisage a crisis that the Italians could dodge.
The pressure on other governments to revisit the long-flawed design of the euro may keep intensifying as the political strain weighs on the ECB.
“It may take the onset of an actual crisis for European Union leaders to be galvanized into action, or for a permanent fiscal backstop to the euro to be crafted,” the BE economists said.
©2022 Bloomberg L.P.
