Gadfly

Germany's Coalition Is Italy's Salvation

A shift toward ever-closer European debt union is good news for Italy and the region's other indebted peripheral nations.
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Italian bonds already had friends in high places. The result of Germany's coalition talks will bring a smoke-filled room full of them.

Angela Merkel's Christian Democrats have finally achieved consensus with the Social Democratic Party, and the chancellor looks to be on her way to starting her fourth term. This grand coalition will hand the SPD control of the finance, foreign and labor ministries. Former Finance Minister Wolfgang Schaeuble, whose surname became synonymous with austerity measures throughout the region's debt crisis, is firmly out in the political cold.

The new German government, if ratified, is going to be far more aligned than it ever has been with the aspirations of French President Emmanuel Macron for even closer European Union financial integration.  

This is an important development for Italy and other peripheral nations. The new consensus moves the bloc closer to developing a robust European Monetary Fund and creating pooled debt issuance, with member states being jointly and severally liable for securities issued as "Eurobonds," or something with a very similar name. 

The road to a joint market is a long one, and assent from EU governments can hardly be taken for granted.

But the direction of travel is important for a country such as Italy, which has more than 1.5 trillion euros of outstanding bonds. That regional support is even remotely on the horizon helps explain why yields on Italian debt and other peripherals continue to tighten to Germany -- even though there's less than a month to go before a general election that could see yet another hung parliament in Rome.

The Difference a Year Makes

Peripheral spreads to the 10-year German benchmark have raced in as confidence in a more united Europe grows

Source: Bloomberg

In the past six months the spread on Italy's 10-year bonds more than German debt has narrowed about 38 basis points to 121 basis points. Yields are negative out to three years. From a lender's perspective this makes almost no sense. Italy's gross domestic product has yet to recover to pre-crisis levels and it is saddled with a debt to GDP ratio of over 130 percent. The amount of non-performing loans in its banks is staggering.

Italian Bad Debt Pile

While non-performing loans have peaked they remain above €170 billion euros

Source: Bank of Italy, Bloomberg

Italy Bank Bad Debts of Domestic General Government and Other Sectors, non seasonally adjusted

The key word here is "almost." Because European officials have learned the lessons of the euro and Greek crises. Were debt investors to take flight because of the March 4 poll, the European Central Bank is ready to step in.

Doubters have only to look to the December 2016 election, when the current Italian government lost a referendum vote on electoral reform. Italian yields barely budged, and they have central bank buying to thank for that. 

Cheap Debt

Italian government yields are negative out to three years

Source: Bloomberg

Expect a similar result this time around because at any signs of political stress the ECB has the firepower to come in and buy Italian debt-- and the market knows it. The support doesn't end there. President Mario Draghi and the rest of the Governing Council are still reinvesting maturing bonds purchased through their quantitative easing program. And QE purchases have decidedly overbought Italian securities.

Not only does the ECB have the markets covered for now, the new German coalition means the rest of the EU cavalry may not far behind. Italy, along with other peripheral countries with higher yields and huge debt loads, could be the big winners.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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