The Eurozone erupts once in a while, causing markets to turn volatile, talk of Euro collapse and generally filling in sound bytes for market commentators. However from deep crisis seen in 2010-11, where bond yields of PIIGS (Portugal, Ireland, Italy, Greece and Spain) rose to almost unsustainable levels and the Euro crashed, (Read our note on PIIGS to refresh your memory) the market and economic conditions in the Eurozone have improved vastly and volatility has almost been forgotten.
Eurozone volatility has once again come to the fore, hurting financial markets. Now, it is Italy’s turn to cause volatility. with elections bringing in a loose coalition of parties seen as anti-austerity and anti-Euro. Italy has seen a new government almost every year for the past many years, many years and it remains to be seen if anyone government can stick around long enough to cause a major upheaval in the nation.
The ECB is continuing to buy bonds at Euro 30 billion a month and it would step in to buy more bonds if volatility gets too high. In the meanwhile, like Mount Etna, which is an active volcano in Sicily and is a major tourist attraction, it is best to watch the volatility unfold but it is not necessary to run for cover. Despite frequent eruptions, Mount Etna has not caused damage to the surroundings or human habitation.
Italy’s impact on Indian equities, bonds, and INR is largely through risk aversion in global financial markets. The Sensex & Nifty would see some bit of correlation to global equities but the drivers will be earnings, economy, and politics. The INR has weakened against the USD over the last two months on many issues but it is on a fundamentally firm ground and is unlikely to fee direct heat from Italy. Bond yields too have risen on various factors and will move largely on incoming data, RBI policy and demand – supply. Read our notes on Sensex & Nifty, INR, and INRBONDS movements.
Italy & Markets
As political uncertainty in Italy intensifies, risk aversion is on the rise in global financial markets. Italy’s president Sergio Mattarella has set the country on a path to fresh elections by appointing a former International Monetary Fund official Carlo Cottarelli as interim prime minister, with the task of planning for snap polls and passing the next budget. The financial markets fear that the elections, which could take place as early as August, are seen as a quasi-referendum over Italy’s role in the European Union and Eurozone and could end up strengthening eurosceptic parties even further.
Such worries have resulted in a big sell-off of Italian debt and a surge in safe-haven German bond prices. As a result, the yield spread between 10-year German and Italian bonds was at its broadest since December 2013. The spread between Italian and German 10-year benchmark bond has risen by 60 bps overnight.
Italy’s 2-year yield spiked by 185 bps to 2.738%, while 10-year bond yields jumped 50 bps to their highest level in over four years at 3.178%. Italian bond yields traded above U.S. Treasury yields for the first time in almost a year.
Italy general election was held on 4th March 2018, since then Italian 10-year bond yields have risen by 117 bps (Chart 1), and spreads between Italy 10-year bond yields and Germany 10-year bond yields have risen sharply (Chart 2).
The deepening political crisis in Italy, which is the euro zone’s third biggest economy has also fueled a heavy selloff in the euro. The fall in the investors risk appetite boosted the yen against its peers. So far in May, euro has lost more than 5% against the yen, which tends to attract demand during political unrest and market turbulence. The euro is down by 7% against the USD on a year to date basis.
The rush for safe havens also saw market participants selling equities in favor of USTs, with the yield on the benchmark 10-year UST falling by 16 bps overnight to 2.77% the lowest level seen since April 2018.
The rise in risk aversion will drive financial market in coming weeks and emerging market could see foreign money leaving the country. The Indian rupee will continue to remain under pressure amid sudden rise in risk aversion. However, the rupee will not see sharp depreciation as it is already in the oversold territory. The crude oil prices stabilizing at these levels will provide support to Indian Rupee. Saudi Arabia and Russia have discussed raising OPEC and non-OPEC oil production by 1 million barrels per day (bpd) to counter potential supply shortfalls from Venezuela and Iran. (Read our analysis on INR’s Reversal of Fortunes, Can it Claw its Way Back to the Top?)
Effect on Indian Bond Yields
The ongoing political crisis in Italy will not have a major impact on Indian Bond yields as India macroeconomic data looks solid, oil prices have peaked out, which will lead to optimism on both inflation and current account deficit, GST collection is also showing improvement, as April 2018 collection exceeded Rs 1 lakh crores, the highest on record, indicating a healthy economy. A normal monsoon, infrastructure-focused spending, faster resolution of stressed assets of the banking sector will also help Indian economy to expand at a faster pace. (Click here to Read our Analysis on factors which suggest Indian bond yields is poised for a rally)