Great 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)

 

Quick update on the Euro

This morning, EZ August flash inflation came in at 0.3% YoY and confirmed falling trend (from 0.4% in July). The ECB meets next week (September 4) and the market is pricing some action: talks of corridor rates cut, updates on the ABS program…

Our advice is ‘stay short EURUSD’ for those who got in already, or wait for a bounce back above the 1.3200 level for entering a short position. Large offers are seen at 1.3200 – 1.3250 (combined with huge expiries, 4bn Euros of vanilla option according to Reuters). Though the first support stands at 1.3100 where we might see a pause, our MT target remains at 1.3000. After German retail sales printed much lower than expected at -1.4% MoM in July (vs. 0.1% consensus), Italian quarterly unemployment rate rose to 12.6% in July (vs 12.3% expected) and preliminary inflation (EU Norm) entered into a negative territory, printing at -0.2% YoY and joining Greece, Spain and Portugal in recording annual consumer-price declines.

Peripheral yields picked up a bit, with the 10-year Italian and Spanish yields trading at 2.44% and 2.24% respectively, up from Wednesday’s low of 2.36% and 2.09%.

Our view goes for a corridor rate cut in order to optimize the T-LTROs (first starting on Sept 18). ABS purchases sound a bit premature…

EURUSD-29-Aug(1)

(Source: Reuters)

Another way to play the Euro at the moment would be against GBP as we believe the market has overreacted to the some data disappointments and a slightly dovish QIR (Quarterly Inflation Report) back on August 13th. Good resistance level is at 0.7960/5, therefore going short EURGBP at around that level with a first target at 0.7880 (stop loss above 0.8020) could be a good strategy. Bank of England is also meeting next week but we expect it to be a non-event.

Euro Zone under pressure

 After a contraction of -0.1% in Q1, Italy reported unexpectedly a 0.2% contraction (first estimates) in the second quarter (vs. consensus of +0.2%). The 10-year yield is now trading at 2.78%, 10bps higher than last week’s low of

It seems that the European Recovery is already over…

Eurostoxx under pressure
Watch the second lower trend line on Eurostoxx 50 as European banks will remain under pressure in the weeks ahead with investors still fearing further write-offs. As you can see it on the chart below, the next support on the downside stands at 3,000, which could lead to a further correction if it breaks it.

ES50

(Source: Reuters)

As you know, European banks are still in the middle of an AQR – Asset quality review – with the results to be unveiled in late October, slightly before the ECB takes over as the EZ official banking regulator on November 4. Some of the people refer the AQR as a form of stress test, and the question investors are asking themselves is if this ‘stress test’ will be effective.

 However, remember smth: back in 2011, a similar exercise was done by EBA (European Banking Authority). Dexia passed the test and then had to be bailed out three months later…

EURUSD remains also under pressure and is now trading slightly below the 50% Fibo retracement (1.2750 – 1.4000). Next support on the downside stands at 1.3300.

EURUSD

(Source: Reuters)