By William Watts, MarketWatch
Italy’s political turmoil is renewing worries about the long-term viability of the euro.
But even as Italian bonds tumble, sending yields soaring, past efforts by the European Central Bank should help stave off a repeat of the worst days of the eurozone debt crisis, at least in the short term, wrote economists at Commerzbank ahead of the weekend. But the ECB, led by former Bank of Italy chief Mario Draghi, can’t paper over the cracks in the euro indefinitely.
Italy was headed for a political crisis after President Sergio Mattarella on Sunday blocked the formation of a euroskeptic government. The move is seen potentially setting the stage for an autumn election that could become a de facto referendum on Italy’s membership in the euro.
That’s accelerated a selloff in Italy’s bond market, with the yield on the 10-year bond, known as the BTP /zigman2/quotes/211347230/realtime BX:TMBMKIT-10Y +0.01% soaring 28.6 basis points to 2.97% Tuesday, while the 2-year yield /zigman2/quotes/211347219/realtime BX:TMBMKIT-02Y +0.24% soared 125 basis points, or 1.25 percentage points, to 2.185%, the highest since 2013. It had stood at 1.74% on May 3, according to Tradeweb. Yields rise as bond prices fall.
The premium demanded by investors to hold the Italian bond over the German 10-year bund /zigman2/quotes/211347112/realtime BX:TMBMKDE-10Y +3.27% went from around 1.26 percentage points in late April to more than 3 percentage points early Tuesday — representing the widest spread since 2013 — and was recently at 2.78 percentage points.
The euro /zigman2/quotes/210561242/realtime/sampled EURUSD +0.5749% fell 0.5% versus the dollar, while Italy’s benchmark stock index, the FTSE MIB /zigman2/quotes/210598024/delayed IT:I945 -1.22% , was down more than 4% so far this week, after dropping 6.6% last week.
The Wall Street Journal reported that hedge funds have homed in on the perceived weakness, increasing bets against Italian bonds to levels not seen since the financial crisis.
Ralph Solveen, economist at Commerzbank in Frankfurt, outlined four ways the ECB’s actions could help limit the threat of a return of a full-fledged crisis, at least for now.
Remember the OMT
At the top of the list is the ECB’s Outright Monetary Transactions program. The OMT program was assembled after Draghi’s famous 2012 pledge to do “whatever it takes” to preserve the euro. Never used, OMT allows the ECB to make purchases of government bonds issued by eurozone countries in the secondary market once a government requests assistance.
Draghi’s pledge and the promise of the OMT program were credited six years ago with pulling Italian yields down from crisis levels that had seen the yield on two-year government paper /zigman2/quotes/211347219/realtime BX:TMBMKIT-02Y +0.24% spike above a fiscally unsustainable 7.5%.
To be sure, OMT isn’t without its flaws, Solveen notes. For one, emergency buying of Italian bonds on top of purchases already made as part of its separate quantitative-easing program could push ECB holdings above self-imposed limit on holdings of debt from any individual country, but it’s a safe bet that the “ECB would not stop there,” Solveen said, “if this is what it takes.”
Second, as highlighted by economists Olivier Blanchard and Jeromin Zettelmeyr in a blog post for the Peterson Institute for International Economics. Access to the OMT program requires a government to strike an agreement with the ECB and EU authorities on an accompanying fiscal plan, which happens to be “the opposite of what Italy’s new government has promised.”
“Unless the government were to change course, it would be forced to exit the euro, even if this is not the current plan,” they wrote.