Watching Italy! Another Debt Crisis in the Making?
Bond markets would look even more stressful if it weren't for the ECB.
Italian 10-year bond yields have hit 5%. The last time we saw this was at the end of 2012. Italy was on the brink of collapsing out of the Eurozone only a year before that. Is a new European debt crisis on the horizon?
Spreads vs. Yields
Many investors fixate on 'the spread' when it comes to countries with high debt levels. According to the IMF, Italy currently boasts a 'chilling' debt-to-GDP ratio of 144%. And this includes government debt only. And it's the yield, not the spread, on that massive amount of outstanding debt that needs to be paid. Considering the colossal spike in yields, looking only at the spread will provide you with an incomplete picture. For instance, the Italian 10-year spread was at 230 basis points a year ago, higher than the current 200 basis points. But Italy's 10-year yield is currently more than one percentage point(!) higher than a year ago.
Debt is costly
Obviously, Lagarde and the ECB - having horrifically missed their inflation target -argue that yields must remain higher for longer to eradicate inflation risks fully. With that in mind, it's worth looking at Italy's so-called 'maturity wall.' If we set aside 2023 for a moment, Italy needs to refinance 32% of its debt over the next three years. That's substantial, to put it mildly. And since yields have surged across the entire yield curve, interest costs will rise significantly independent of whether you refinance using short or long maturities.
Worse than 2010?
From this perspective, the situation is more critical than at the end of 2010, just before the European debt crisis erupted. All yields up to a 15-year maturity are (much) higher than they were thirteen years ago. The shorter Italy refinances, the more painful it will become. For example, the Italian 2-year yield is nearly 200 basis points, or two percentage points, higher than at the end of 2010. Rolling over debt will hurt, period. By the way, did I mention that Italy's debt-to-GDP ratio in 2010 was 'only' 119%?
6% of GDP?
If structurally higher yields do become the 'New Normal' – something I don't believe in – Italy could face interest expenses on its debt of at least 5%, but more likely closer to 6% of GDP. This is without factoring in the primary budget deficit. Even if inflation settles at a structural 3% – something I do believe in – Italy's debt-to-GDP ratio will rise. After all, Italy generates almost no real GDP growth.
ECB (always) to the rescue
Yet, there is no sign of stress in the Italian bond market. The reason for this is simple. Since the European debt crisis in 2011-2012, the ECB has systematically and extensively supported countries facing rising yields. A brief look at the many programs with just as many abbreviations established since then confirms this. The graph below from the ECB reveals that within these programs, bonds have mainly been purchased, with very few sales so far. The largest bond sales have occurred through the ‘Public Sector Purchase Programme’ (PSPP), part of the broader ‘Asset Purchase Programme’ (APP). But this is 'peanuts' compared to what it is on the ECB's balance sheet.
The following graph illustrates ECB PSPP holdings for Germany and Italy. In general, there has been very little reduction, even when inflation reached its highest point in four decades. And no surprise, Italian bond sales have been smaller than that of German government bonds. Compared to the peak, ECB PSPP holdings for Italy have decreased by just 4%, while for Germany, they are 6%.
Magic Black Box
And don't forget, the next ECB program has already been launched. The Transmission Protection Instrument (TPI) was set up intentionally vague, allowing it to be flexible when the shit hits the fan. It's like a 'magic' black box with zero binding or fixed conditions attached. Consequently, Italy's bond spread should be 'safe' in the next crisis, right?
Things That Make You Go Hmmm
Facilitating 'debt sustainability' has undoubtedly become the ECB's secondary or shadow goal. And the recipe remains the same over and over again: lower yields and direct bond purchases. However, this ongoing financial repression also significantly affects the broader financial markets and your investment portfolio. People are increasingly concerned about the financial system, their investments within it, the euro, and the repercussions of all this artificial central bank liquidity. It's crucial to adjust your investments accordingly. More on this soon!