The Italian Job: A Threat To Euro Area Stability

The foreign exchange market has calmed after initial follow through to the dramatic price action in the North American afternoon yesterday as it became clear that the Italian election was not going to produce a majority in the Senate.

While several large countries, like the US, Germany and Japan, have divided houses, the problem in Italy is no party has a majority. And the poor showing for Monti and the exceptionally strong showing of Grillo's 5-Star Movement means that the much heralded center and center-left coalition is insufficient to secure a majority.

The situation needless to say is very fluid and although the euro has stabilized, the threat to euro area stability is clearly evident in the debt markets where Italy's 10-year yields has soared 32 bp and the spread over Germany has widened by more than 40 bp. Other peripheral bond markets are also under pressure as are the credit defaults. Equity markets are also taking it on the chin. Italy's bourse has been crushed, losing more than 4.5% and dragging down the other markets as well. As one would expect, the financials sector in Europe is the hardest hit, underscoring that the link between sovereigns and the banks remains tight.

There are broad and narrow implications of the election. Some will see the majority vote for the parties that want to leave EMU as the beginning of the end, sparking a new phase of the financial crisis. Austerity has so weakened the social fabric that it has eroded the political center. A political crisis is more immune to ECB action and the OMT than a private capital strike. However, it may be jumping hastily to a conclusion that all who voted for the center-right and Grillo did so to express a desire to leave EMU. There were many reasons why the voters would want to express disapproval of the technocrat government that promised better days but failed to deliver growth or jobs.

The narrower interpretation would suggest that while there will likely be much posturing in the coming days, a center-right and center-left coalition on a fixed and limited program that would include the naming of a new president (current terms expires mid-April), perhaps some limited stimulus, and electoral reform that sets up for new elections in a few months. Perhaps this is too much to envision immediately and the Italian politicians may have to try the other alternatives before choosing the most sensible.

The 5-Star Movement, is the largest single political party in Italy and yet the anti-political stance makes governing impossible. Grillo is quoted in the media as saying "No deals. Its a War." To those who are susceptible for confusing metaphors for reality (see currency war), Grillo is declaring a political war against the political elite, but that same strident stance may make him irrelevant to forming a coalition.

Italian developments are overshadowing other important developments. In Japan, it is looking increasingly likely that Asian Development Bank head and former MOF Kuroda will be the next BOJ Governor. The naming of the BOJ team is the last piece to fall in place, we suspect, before investors give Abenomics its real test. The violent recovery of the yen over the past 24 hours is not driven by Japanese developments of course but the unwinding of the risk-one trade due to European developments. The yen's recovery took the shine of Japanese shares and the Nikkei tumbled 2.25%.

If the purpose of QE is to drive down interest rates and more aggressive asset purchases will be seen under the new BOJ regime, how much lower can yields be driven in Japan? What is ultimately desired are structural reforms the increase capacity of the economy--not through fiscal spending, but, for example, broadening the labor force participation and opening up more parts of the economy to competition.

In the US, the first leg of Federal Reserve Chairman Bernanke's semi-annual testimony is the main feature. We think many observers read the recent FOMC minutes in a way that gave too much emphasis to non-voting regional presidents and not enough to the Board of Governors, and especially, the Fed's leadership. Bernanke is likely to reaffirm the accommodative stance and, with European tensions flaring, can point to external risks as well as domestic. The sequester, which includes $85 bln in new spending cuts for the remainder of the fiscal year, also part of the domestic headwinds that the economy faces.