Europe finds itself at a troubling crossroads: while on one hand the official narrative emanating from Brussels and Berlin (and, of course, the ECB) is that there is no risk of contagion from Italy’s budget crisis in the European Union, on the other hand the euro zone is "not prepared enough to face a new economic crisis", French Finance Minister Bruno Le Maire told daily Le Parisien on Sunday.
“We do not see any contagion in Europe. The European Commission has reached out to Italy, I hope Italy will seize this hand,” he said in an interview.
“But is the eurozone sufficiently armed to face a new economic or financial crisis? My answer is no. It is urgent to do what we have proposed to our partners in order to have a solid banking union and a euro zone investment budget.”
Le Maire's remarks come just days after the European Commission rejected Italy’s draft 2019 budget earlier this week for breaking EU rules on public spending, and asked Rome to submit a new one within three weeks or face disciplinary action. And while Brussels officials said that Rome’s "unprecedented" standoff with Brussels seems certain to delay the reform process and probably dilute it for good, Italy has remained defiant and has repeatedly said it would not budge on its target deficit at 2.4% of GDP.
The standoff between Italy and the EU, and concerns about who will buy Italian debt after the ECB ends its QE at the end of the year, has sent Italian yields soaring to the highest level in nearly 5 years.
The blowout in yields has sparked panic in some official circles, with the Peterson Institute for International Economics warning that if Italy is headed for a debt crisis, it would be “horrific,” according to a May 2018 report which blamed the higher rates on a "political backlash to slow growth and immigration" which has "produced the least cooperative government imaginable, a coalition between the left-populist Five Star Movement (M5S) and the right-populist Lega."
Meanwhile, a growing risk is how much time Italy has before the market revolts ahead of the upcoming end of the ECB's QE. As the following chart from Deutsche Bank shows, the central bank has been the only net buyer of Italian debt, serving as backstop to the broader market which will soon be over...
... although in recent months Italian banks have been on a debt buying spree, sparking concerns about Italy's "doom loop", where any blow out in yields results in an immediate hit to bank stocks, and financial stability.
Meanwhile, in what can only be interpreted as a disastrous negotiating tactic, last week, Italy's Cabinet Undersecretary Giancarlo Giorgetti said in an interview on Italy's RAI that Italian banks would need a "recapitalization" if the spread with German bonds continues to rise toward 400 basis points, from the current level of 310bps which is just shy of the widest level it has been going back to early 2013.
With the market on edge, and Italy's standoff with the EU likely to go the distance, the bond vigilantes will be all too happy to test just what happens when the 400 bps threshold is crossed and a more pressing question is at what level in "lo spread" will Italian households decide they have had enough of this "game of chicken" and pull their money out of the banks, a process which will only culminate with a test of the French finance minister's dire warning.