Matteo Renzi – prime minister with ambitious agenda

Looking ahead March-June (central banks, Eurozone)

Last week, Matteo Renzi was sworn in as Italy’s youngest-ever prime minister in history. Renzi managed to decide the internal power battle of the Social-Democrats in his favor and replaced Enrico Letta, the former prime minister. Renzi, head of the Social-Democrats since December 2013, blames the Letta government for making hardly any progress on major reforms. Renzi has laid out an ambitious working program for the first 100 days of his government in order to implement important institutional (electoral law and constitution) as well as structural (labor market, taxes and administration) reforms. However, given the fact that Renzi’s government consists of the same heterogeneous party constellation as the Letta government, it remains to be seen how quickly and effectively the intended reforms can be decided upon and implemented. As a sign of the willingness to reform, the new government is smaller (16 instead of the previous 21 members) and half of the members are female. In 4Q13, the Italian economy managed to return to growth. Hopefully, the Renzi government will be able to give the economy further positive impulses with the speedy implementation of major reforms. The new government intends to remain in power until the next regular elections (expected to take place in 2018).

Looking ahead March - June

ECB: Inflation likely to remain below 1% (1.2% in 2015) and thus further action by the ECB is very likely:

1) Cut of the MRR to 0.1% (a cut of the deposit facility rate below zero only if further downside risks, i.e. not within next three months)
2) Liquidity: cancelling sterilization of SMP program increases liquidity by approx. EUR 175bn.
3) Purchase program. Classical QE (purchases of government bonds according to the ECB key or GDP weight, etc.) do not seem likely due to opposition in Germany. More targeted purchases – ABS purchase program similar to the covered bond purchasing programs – are more efficient and more in the spirit of the ECB, but are not technically ready.

Market reaction: German yield curve. Except for a true QE program, the effect of further measures on the German yield curve should be limited. Rather, if no measures would be taken, downside risks to longer-term rates and yields related to declining inflation expectations and deflationary risks could appear. Given our expectation for an ongoing recovery and very low inflation, combined with further ECB action so as to counteract inflation rates sustainably below 1%, we expect German yields to increase very moderately in the medium term – unless recent turbulence was to last and led to persistent safe haven flows.

Fed: The Fed is likely to continue its gradual reduction of additional purchases by approx. USD 10bn per meeting, ending purchases late this year (or early 2015 if the soft patch in economic data persists). The first rate hike is not, however, to be expected before mid-2015; the Committee will soon issue a stronger statement than low rates ‘well past the time that the unemployment rate declines below 6.5%’ as unemployment is at 6.6% already now, e.g. by including inflation.

Eurozone: The main topics on the agenda of European bodies (Eurogroup, Ecofin, European Council) for the next three months will be:

- Banking Union: agreeing the regulation of the SRM (final agreement expected ahead of European elections in May); finalization of the operational framework for the ESM direct recapitalization instrument; progress regarding the SSM (AQR and stress-test).
- Greece: pending decision on potential debt relief (Eurogroup currently sees no need to discuss debt relief ahead of August) and fixing of the funding gap for 2014 and 2015. Greece is currently behind schedule with reforms and finalization of the fifth program review still pending.
- Portugal: discussion of strategy for program exit by June. As a result of successful bond placements (5-YR and 10-YR), Portugal has already covered its entire mid- to long-term financing needs for 2014 in February; this should support a clean exit.

We expect that in the next couple of months, investors will closely watch whether Matteo Renzi will succeed in implementing his ambitious reform agenda in Italy. European Parliament elections are scheduled for May: no parliamentary decisions are expected for a period of transition thereafter.