February 2, 2017, by Dr. Christian Witt (YCAP Asset Management)
As you may have certainly noted, Italy has been very much in our focus recently (European Reflation, Italian referendum, Europe: Running Out of Time?). This is neither to annoy nor to bore you, but an expression of our growing concerns about the diverging economic forces in the Euro Area. They could tear the common currency apart. And Italy is at the very heart of this unhealthy and deepening divergence. So, is Italy in peril?
Our main argument (we do not get tired to repeat) is the small but genuine risk of a downward spiral. The story goes as follows. As overall inflation rises, the ECB may be forced to start tightening sooner than later. Accordingly, sovereign yields begin to rise in the Euro Area. This is bad news for countries with subdued inflation such as Italy. For their real yields remain elevated although they would need lower ones to support economic growth. Against Italy’s poor record of economic performance and high debt, this might push the country over the edge at some point. What could make matters worse is that investors have an incentive to bid up sovereign yields more aggressively compared to other countries in anticipation of future economic weakness. A vicious circle.
Let us confront this hypothesis with reality. Newly released inflation data suggests the Eurozone as a whole experiences much faster price growth than Italy (see Figure 1). In terms of core inflation (see Figure 2) the difference is wider still. Check. Pundits start debating monetary tightening (Société Générale, Bloomberg). Check. 10-year sovereign yields are on the rise (see Figure 3). Check. Real yields are elevated in Italy (see Figure 4). Check. Italy’s sovereign yields spread widens vis-à-vis the German benchmark (see Figure 3). Check. Signs of a vicious cycle. Perhaps, since the Italian unemployment rate has risen of late despite a generally favorable trend in the Euro Area (Figure 5).
The analysis shows that a downward spiral in Italy is still a worrisome but possible scenario, even if reality might turn out differently in the end. Dark clouds are hanging over Italy. Still, it may rain elsewhere. We will continue to monitor the development closely.
Figure 1: Inflation Rate, %yoy.
Figure 2: Core Inflation, %yoy.
Figure 3: Italian and German 10-Year Yields, 31/12/2014=100
Figure 4: Real Yield Spread: Italy vs. Euro Area Benchmark. (Core) Real Yields Defined as 10-Year Sovereign Yields Less Headline (Core) Inflation.
Figure 5: Unemployment Rate and Difference, %