Weekly Chart: Italy EPU Index vs. 10Y Bond Yield

The recent results in Italian’s election held on March 4th wasn’t really a surprise for market participants, with EURUSD barely moving (the pair is actually up 2.5 figures over the past week) and the 5Y CDS spread (vs. Germany) flat at around 92bps (here). According to the latest estimates, the populist Five-Star movement, created by comedian Beppe Grillo and led by its prime ministerial candidate Luigi di Maio, came in first individually capturing 32.7% of the votes. However, if we look at the coalitions results, the Center-Right coalition got 37% of the vote shares, with the alliance including the League with 17.4%, former prime minister Silvio Berlusconi’s Forza Italia (14%) and the Brothers of Italy (4.4%) and US with Italy (1.3%) parties. The disappointment was for the Democratic Party, which has governed Italy since 2013, as the Center-Left coalition captured ‘only’ 23% of the vote shares (much lower than the 27+% estimates, here), prompting former PM Matteo Renzi to step down as party leader. The FT published an interesting graphic lately, showing the geography of the electoral vote: Italy, the politically divided country (here). As you can see it, the Five-Star movement made the largest gain in the South (including Sardinia), in regions with the lowest per capita income.

Hence, following the election results, an interesting chart to watch in the weeks to come is the 10Y Bond yield vs. the Italy EPU index. As a reminder, the Economic Policy Uncertainty (EPU) index was developed by Baker, Bloom and Davis (2016) as a measure of economic policy uncertainty based on newspaper coverage frequency. The authors studied the evolution of political uncertainty since 1985 across countries (12 including the US) using leading newspapers that contain a combination of three of the target terms: economy, uncertainty and one or more policy-relevant terms (For the European EPU index, the author used two leading newspapers per country). Since its inception, the index has gained popularity in practice, measuring another form of market’s volatility or uncertainty. Baker et al. found that elevated political uncertainty has negative economic effects, which can potentially impact market prices.

This chart plots the EPU index versus the Italy 10-year bond yield. We can observe an interesting correlation between the two series. Since the financial crisis, it looks like LT sovereign yields have been rising when the EPU index increased ahead of a political or economic uncertain event. For instance, during the European debt crisis of 2010 – 2012, the EPU Index for Italy rose from 75 to over 200, while the 10Y yield skyrocketed from 4% to 7%. The financial meltdown in the Euro area was then halted after ECB Draghi’s “Whatever it takes to preserve the Euro” famous words at a global investment conference in London on 26 July, 2012.

As we mentioned in our previous posts, we don’t see any imminent risk for Italy, however a potential threat to investors would be a prolonged period of political instability. The question now is: can a rise in Italian LT yields in the next few months lead to a contagion to other peripheral countries’ bond yields (i.e. Spain or Portugal, here)?

Chart: Italy EPU Index (lhs) vs. 10 bond yield 

(Source: Eikon Reuters, policyuncertainty.com)


June rate hike? What Yellen (and the Fed) faces…

I have to admit that by just looking at the government bond yields (see appendix), I am asking myself a lot of questions about the stability of the economy and the financial markets. However, one particular point that matters the most is the Fed’s June rate hike.

Therefore, this article aims to give an update on the four major risks that can lift-off the central bank’s monetary policy decision for later this year, which are the following topics:

  • China slowdown
  • Dollar strength
  • Oil prices
  • Grexit: Greece and all its 2015 payments
  1. China Slowdown

It is clear that commodity prices have dropped dramatically over the past year based on a lower than expected Chinese growth (i.e. global demand). If we look at the last figures, analysts expect China to grow by approximately 7% in 2015, down from the last 7.5% projection (in late 2014). Last week, we saw that the economic output grew 7% YoY in the three months of 2015, down from 7.3% in Q4 last year and now standing at its slowest rate in six years. What really concerns me is that I read several times the word ‘approximately’ in analysts predictions of China 2015 growth, this means that we could see an actual lower than 7% figure, especially in the middle of this geopolitical war.

In the housing market, it looks like the economy is experiencing a sort of ‘real’ correction: if we look at on of Chinese Housing Market ‘benchmark’ – China 70-city Home price change – the last report showed that house prices decreased 6.1% YoY in March, its eighth negative print in a row and the biggest drop in history.

It is hard to believe that after a 15tr USD increase in total Chinese Bank assets since September 2008, the economy is still struggling to achieve a healthy growth. The obvious response from Beijing officials was to cut its Reserve Requirements Ratio by 1% to 18.5% (last one was a 50bp cut in early February), ‘flooding the market’ with liquidity and participating – like the rest of the World – to this massive monetary stimulus.

What the PoBC cut a sort of ‘preparation’ to the Fed’s action?

Maybe I know too little about the Chinese economy (and history), but it is curious too see that some financial experts have a totally different interpretation of China.

For instance, in the last discussion that I had with a (very) experienced economist, I asked him ‘Where do you see the most interesting opportunities at the moment for medium term investments?’

He answered me: ‘Well, there are three countries you should invest in: China, China and China!’ He started his quick analysis about the massive internal migration of young new dwellers moving from rural to towns and cities (between 10 and 20 million each year according to NBS). Chinese major cities will host approximately 60% of the country’s total population (permanent urban residents) by 2020 (slightly above 50% now), therefore playing in favor of Chinese Fixed assets, companies’ valuation,… However, I was asking myself: ‘What about work conditions and salary increase? We learned from the last GFC that you can’t reach a sustainable economy with a divergence between median annual incomes and home prices. In addition, you can’t build a strong economy based on speculative stories and artificial growth (look at the Spanish situation now after the correction in the housing market).

Moreover, this scenario was based on a strong assumption that relations between China and the US remain stable (i.e. no pressure from the West to abolish the exchange rate peg). This is clearly not obvious, especially in this new (sort of) Cold War between East and West. If we look at the US Treasury website, we can see that China has reduced its US Treasuries by 50bn USD over the past year (its US holdings stand at 1.224Tr USD as of February). If this trend continues, pressure from US officials to drop the peg will be more and more a serious debate.

Besides that digression, it seems that we are going to see some downward revision in China, which will obviously be a persistent topic at the next FOMC statements.

  1. Dollar strength

The topic that I love to discuss is the Dollar strength. Described as the most crowded trade of the year, it is clear that a constant strengthening greenback will be problematic for the US economy, especially now that the Fed has stepped out of the bond market. Even though we saw a sharp reduction of the government’s deficit in the last two fiscal years (the annual US budget deficit fell from 1.1tr USD for FY12 to 483bn USD for FY2014 as you can see it in the chart below – equivalent to 2.8% of the country’s GDP), the US still runs large current account deficits (coming from consistent trade deficits) which forces them to rely on external funding.


(Source: WSJ)

A strong dollar wouldn’t help to ‘redress’ the balance of trade (i.e. exports are less competitive), and will obviously decline companies’ sales and reduce the economic output. Pessimist Atlanta Fed forecast a zero-percent growth for the first three months of this year, down from 1.9% in early February. The market is more bullish anticipating a 1.4% rise.

The July Fed Funds Futures implied rate is at 15bp, while September and December are trading at 21bp and 34.5bp respectively. From that perspective, I will opt for a September move (vs. June).

  1. Oil prices

As you know, oil prices fell sharply in the second half of last year, bringing to an end a four-year period of stability around $105 per barrel. If we look back at prices’ history since the early 80s, there has been four other relevant declines prior to this one:

  • Increase in oil supply and change in OPEC policy (1985-86)
  • US recessions after the S&L crisis in 1990-1
  • The Asian crisis of 1997
  • The Great Financial Crisis 2007 – 2008

Today, the causes of the Sharp Drop could be explained by multiple factors: a change in OPEC policy objectives (no intervention from Saudi Arabia in the last OPEC meeting on November 27th last year), increasing production (US Production of Crude Oil now stands above 9ml barrel/day, up from 5ml 7 years ago post GFC), receding geopolitical concerns about supply disruptions in the Middle East and between Russia and Ukraine, a sinking global demand and a US dollar appreciation. It is hard to define which of these factors was the most important, however I would say the expansion of oil output in North American due to the US Shale revolution (and Canada oil sands) and a declining global demand both weighed on oil prices.

Although low oil prices (and other commodities) is seen as a sort of stimulus for consumers by analysts, I am very confident that it is also the explanation of the late decrease in inflation expectations in all the Western countries. The table below shows you the Consumer Price Index of the major economies:














2.2% (February)


Even the 5y/5y forward swap rate, what central banks watch as an indication of inflation expectations, has fallen to unprecedented sub-2 percent levels in the US, which is going to be problematic as Yellen and (most of) the Fed’s Board have considered that it is time for monetary policy tightening – the so-called neutrality.

In addition, low oil prices could also be a burden for all the high leveraged shale oil companies in the US. The chart below (source Bloomberg) gives us a quick idea of where oil prices have to stand so that shale companies are (at least) breakeven. According to the sell side research, breakeven prices for US shale oil are within the $60-$65 window. WTI May futures contract is still trading below those figures at a shy $56.


(Source: Bloomberg)

  1. Grexit and the contagion effect

With the 10-year yield now trading at 13% (and the 2Y at 29%), it is clear that the market is anticipating disappointing negotiations between the new Greek party and the Troika. There are lots of good articles that came out lately about Greek’s situation, but that could easily be summarize by the chart below. This clearly shows that there are going to be a lot of meetings with European officials before the Summer, and the Tsipras government will have to innovate its list of reforms in order to free up funds and service its short-term obligations.


(Source: IMF)

What’s next then? Let’s assume Greece makes it way through the summer (the two 3bn+ payments to the ECB) without catching a cold, this is only the 2015 chart and there are plenty of more years to come. No borrowing from the financial market and an unstoppable increasing debt (see article Pocketful of Miracles). A situation that could only deteriorate in my opinion…

In the latest news, Bloomberg reported that the Greek government issued a legislative act yesterday that requires public sector entities to transfer idle cash reserves to Bank of Greece (i.e. capital controls) as the country is willing to serve its next €1bn debt obligations to the IMF next month.

To conclude, we may see a symbolic 25bp hike at the June FOMC meeting, however I am certain that we are far from the so-called long-run neutrality rate of 3.5%-4%. If the weak global macro environment persists in the medium term, we are constantly going to see downward revision in the Fed’s dot plot.

Appendix: Government bond yields