Fear ruled the day Monday on our Memorial Day holiday, and when fear is present, the financial markets are upset. It was Italy this time. Political unrest and the discussion of leaving the European Union are the main cause of this defacto move on the euro. In a nutshell, in Italy and many European countries, there are groups that just do not want to stay with the European Union. One of its impacts has been widespread unemployment and anger among the public.
Let’s look at the numbers. The euro sank, losing 0.7 percent Tuesday to $1.1540, and investors dumped Italian bonds while seeking safety in U.S. Treasuries and German bonds. The 2-year Italian yield briefly lifted above 2.73 percent, a sharp move from just 0.48 percent on Friday and a negative yield earlier this month. Global equity markets dropped, with the Dow tumbling more than 450 points. Banks led the selloff, and the S&P financial sector declined more than 3 percent.
As of today, the U.S. equities markets have shaken off the Italian concerns for more positive economic news at home. With payrolls rising and unemployment falling to 3.8 percent, there is much to cheer about. The Italian markets aren’t really a bellwether for the European Union or the euro. Most analysts think that the huge volatility earlier this week was trading related and just making poor investments. Hedge funds and other big banks have been betting on Italy in recent months, and when the time came for everyone to get out the door, there was not enough room, or liquidity to make this happen, hence the price volatility.
In addition, we have to remember that there is still sovereign debt issued by countries in the EU like Italy, that are not euro denominated, and thus are considered by many to be somewhat risk-free instruments like that of U.S. issues. “In the past few years, the sovereign bonds of Italy and other southern European countries have been increasingly traded like risk-free assets, said Zoeb Sachee, head of euro government-bond trading at Citi.” As was shown this week, this is not the case, as the flight for quality to dollar denominated bonds was in full force. When the yield curve is steeper in places like Southern Europe, investors will migrate there for the added basis points.
Cumulative Monthly Debt Purchases by Foreigners
As of this writing, the Italian markets are very fluid, and are reacting positively to the election of Giuseppe Conte, who is set to be sworn in as Italy’s new Prime Minister today and put an end to the political deadlock that has engulfed the country since the election on March 4 did not produce a government. Italian bonds rallied hard Friday and stocks rose 2.8 percent. But the Italian saga looks far from over. With Moody’s already reviewing Italy’s Baa2 rating for downgrade, a one-notch cut would leave Italy at the bottom of the investment-grade category. This combined with a neophyte government will likely see investors heading for the sidelines in the near term. Those with an appetite for risk will continue to matriculate to Italian debt, but with more hedged positions and less outright exposure.