Italian politics – an ancient Roman tragedy
Finally, there has been some breakthrough relating to a new government formation in Italy. M5S leader Luigi Di Maio was asked to form a government coalition by President Sergio Mattarella a few weeks ago and this weekend a draft agreement between the M5S and League was leaked to the press. Prior to the election, we described this as the worst possible outcome of coalition formation for the economy/markets/Brussels. While M5S and League have pulled back on some of their election proposals, a leaked draft document (which M5S later said was an old version) has taken a toll on markets. The markets took note of it; in particular, markets ridiculed the call for a EUR250bn debt forgiveness from the ECB's QE purchases. In the current proposal, reform rollback and flat tax rates (at reduced levels) would be key drivers for significantly higher debt levels. We discussed the concerning debt dynamics prior to the elections, when we projected debt/GDP would reach 156% in 2028 with the current government alliance. The Italian-German 10Y benchmark spread is now higher than on Election Day.
Financial markets have reached some milestones this week. The 10Y US treasury yield broke 3%, to reach 3.12% at the highest with no particular driver, albeit with plenty of speculation about a further rise in yields. We still stick to the view that yields will be range bound in coming months and that this week's sell-off is temporary. The euro has been trading below 1.20 all week, as Italian jitters have weighed on FX. A remarkable recoupling of the cross with relative long-term (real) yields has been seen over the past three months though, as US yields have broken key levels, while German yields have not risen to the same extent. We expect the EUR/USD cross to settle in a new range around the current level near term but it remains a buy on dips on a 6-12M perspective. For ECB monetary policy, we also note the trade-weighted exchange rate is now below what it assumed in its staff projections in March, which could support (core) inflation ahead.
On the geopolitical front, North Korea's Kim Jong-Un cancelled a meeting with South Korea and has threatened to cancel the summit with US President Donald Trump in Singapore on 12 June. North Korea is unhappy with the military drills by undertaken by the US and South Korea, which he sees as a provocation. It is likely the drills are intimidating him and Un would need a guarantee from Trump before unwinding the nuclear programme. Further on geopolitical concerns, following the US withdrawal from the Iran nuclear deal from 2015 and the US's intention to reinstate the highest level of economic sanctions on Iran, the oil price has risen markedly. In addition, the US inauguration of an embassy in Jerusalem has not improved the situation. We see further upside risks to the oil price.
Deepening the EU has been on the agenda since Emmanuel Macron took office last summer and the key event all policymakers in the EU are looking forward to is the 28-29 June summit. While the stakes are high, the views are different. France wants risk sharing, while Germany wants risk as part of further integration. This leads us to believe that we are likely to get only some cosmetic initiatives so French President Macron does not lose face. Germany is still lukewarm about further eurozone integration, as Angela Merkel also pointed out last week. While the German government per se is not against the fundamental principle of eurozone integration, including a greater degree of risk sharing and budget co-ordination, there are two major obstacles constraining German support: (1) German mistrust in the EU institutions' ability to enforce rules versus member states and (2) widespread scepticism among the German public about euro area reforms.
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