The second estimate of first quarter GDP is out this morning and it dipped unexpectedly from 2.3% to 2.2% as consumer consumption was revised lower from 1.1% to 1.0%. The market was looking for an unchanged 2.3% print. The price measure (Core PCE QoQ annualized) dipped from an originally reported 2.5% to 2.3%. Meanwhile, the ADP Employment Change report missed with 178k private sector jobs created in May versus 190k expected. Also, the April figure was revised lower from 204k to 163k. The ADP report has been a poor predictor of the official jobs report which is expected to show 190k new jobs versus 164k in April. While the softer market information this morning would generally spark some buying interest in Treasuries the sharp rally from yesterday is being partially undone after some slightly soothing words out of Italy. That’s not to say the flight-to-safety trade from the Italian drama is over (more on that below), but given the size of the moves yesterday some give back had to be expected. Case in point, during yesterday’s trade the 10-year yield had shed 36 basis points from the cycle high of 3.12% less than two weeks ago. Most technical measures are overbought so it’s reasonable to see some backfilling off the strong rally. The 10-year yield dipped as low as 2.76% yesterday and is currently sitting at 2.84% which is the 100-day moving average. The next line of support comes in at 2.91%, the 50-day moving average.
|Economic News||Italian Debt Yield Increases Spread to Others||Agency Indications|
The market is being driven by one thing right now, despite the upcoming first-tier economic releases. That one thing is the Italian political drama that is creating the strong flight-to-safety trade that appears to have some legs to it. Thus, our Treasury market will be the beneficiary for the time being. What has investors troubled is that the Five Star Movement/League coalition’s choice of finance minister was rejected by the Italian president. The minister-to-be, Paolo Savona, was a noted euro skeptic with rumors that he harbored notions of leaving the euro. The Italian president, Sergio Mattarella, as is his right in the Italian Constitution, rejected the appointment noting Mr. Savona posed a risk “for Italian families and their savings.”
The coalition’s leaders are now calling Mr. Mattarella’s decision the end of democracy in Italy, though doing so was firmly within his constitutional powers. They have threatened to impeach him, but they’ll never gather the majority of Parliament or the support of the public necessary to do so. While the neophyte leaders of the populist Five Star Movement and League denounce Mr. Mattarella’s ruling, the president has asked Carlo Cottarelli, an economist and former IMF director to form a caretaker government and nudge Italy toward new elections. He earned the nickname “Mr. Scissors” for his budget cutting talents but that is not likely to be what the Italian citizenry want after voting in parties looking to relax tight austerity budgets and spending constraints.
The risk for investors is two-fold: (1) it’s thought that an election could take place no earlier than September allowing uncertainty and volatility to fester, and (2) it’s very possible, given President Mattarella’s actions, that an even more populist result could take place in the new elections. With a stronger mandate from the voters, a more populist government could be the outcome of the new elections and one that is decidedly more EU/euro unfriendly.
While the League’s campaign message was anti-immigrant, the Five Star Movement’s guiding principle was more a chafing over the years of EU-inspired austerity budgets following the financial crisis. They plan to cut taxes, increase social spending, and even talk about instituting a minimum annual income for all. That increased spending and reduced taxes would obviously exacerbate Italy’s deficit and increase its debt-to-GDP ratio. For a country with the second largest debt in the EU, and fourth largest in the world, bond market investors have taken notice quickly.
The Italian 2-year note has risen from a negative yield of –0.37% on March 30, to a high of 2.64% as of yesterday. The 10-year bond has risen from a low of 1.71% on April 18 to 3.13% yesterday. Imagine the funding costs if Italy did leave the euro and reinstituted the lira? With a debt-to-GDP ratio of 130% Italy has enjoyed low funding costs via the euro and with the ECB’s purchases of sovereign debt. If the higher yields stick, and if they were to leave the euro, the funding costs on the outstanding debt would become crippling.
Other peripheral debt is being dragged into the maelstrom. Portugal, Spain and of course Greece are all seeing lower prices and higher yields as a result of the Italian affair. In addition, Spain is having it’s own political troubles as the Rajoy government is facing a possible no confidence vote this Friday due to corruption convictions among former officials of the Rajoy government. His center-right government is at risk of being replaced by the center-left Socialist Party.
While the European troubles aren’t enough to derail the Fed’s June rate hike, if the volatility and uncertainty remains through the summer it could raise doubts that the Fed gets its planned third hike for 2018. A week ago the odds of a third hike by December 2018 were 92%. Today, those odds are at 63%. That’s a better-than-even expectation that we see three hikes this year, but the near certainty of that position a week ago has been knocked back a bit given the events in Europe.
Italian Debt Yield Increases Spread to Others
The price tag for Italy’s flirtation with populism is rising, with confidence in the economy sliding and bond yields going through the roof. The situation in Italy, the European Union’s third-biggest economy, is also raising concerns about other so-called peripheral countries, Spain and Portugal. The white line is the Italian 2-year yield spread over Germany while the purple line is the Portuguese 2-year spread and the blue line the Spanish 2-year spread over Germany. With Moody’s threatening a ratings cut for Italy, funding costs are getting more expensive for Italy and peripheral countries of the EU.
Agency Indications — FNMA / FHLMC Callable Rates