The Country to Cause Financial Unrest

The Country to Cause Financial Unrest

Interest rates have been falling for 35 years now. But it’s never been a smooth trend. They’ve spiked along the way, at times. When that happened, someone, somewhere, copped it.

It’s a prodigious list.

In 1987, came the 1987 Wall Street crash.

In 1998, we had the Asian Financial Crisis.

In 2000, the Nasdaq stock bubble burst.

In 2008 came the GFC.

In 2012 is was the crisis of the European ‘PIGS’.

The evidence is quite clear. Rising interest rates played a role in all of these. They’re downright dangerous.

So who’s in for it this time around?

Well, Turkey and Argentina are already stumbling. Their currencies are crashing as investors worry about their ability to pay back their foreign debts.

Emerging market stocks entered a bear market this week thanks to the turmoil. But I’m not sure rising interest rates are finished with you yet.

But it’s Europe – specifically Europe – that I worry about.

Here’s why.

The European Central Bank buys bonds as part of its monetary policy.

However, the state of Italy’s finances are so severe their credit rating may be downgraded.

Other euro countries could suffer the same fate.

The ECB won’t be able to purchase these by law if ratings agencies downgrade European sovereign bonds far enough down.

In 2012, Portugal and Italy escaped this fate by the skin of their teeth.

Today there are new ECB rules. If any European government bonds lose their investment grade rating, that nation must comply with EU austerity packages to get ECB support.

You are the weakest link: Goodbye

This would be a major problem.

ECB purchases of government bonds have in recent times run at a pace seven times the net amount of European government bonds being issued.

That means the ECB was financing European government deficits seven times over.

In the understatement of the century, Joost Beaumont from ABN Amro told the Financial Times last year that, ‘There are not many debt markets that are not distorted in the euro area.’

But notice how he is referring to debt markets generally, not just sovereign debt. The same Financial Times article went on to detail the extent of ECB interference.

Covered bonds – 27% of the entire covered bonds market is owned by the ECB

Government bonds — €1.34tn

Corporate bonds — €61bn

Asset-backed securities, which include mortgages, credit card debt, car loans and other consumer credit — €23bn

How anyone can think European bond yields reflect any sort risk or reality is beyond me.

But what happens when ECB Quantitative Easing (QE) policies come to an end? This is the policy that causes it to buy these bonds in the first place.

I don’t know the answer to what happens. We’re all going to find out what the markets really think about European debt at that point.

My guess: interest rates are at risk of spiking.

The ECB is supposed to end its support for the European bond market in coming months. And one country is pushing its luck in bond markets at the same time.

The Financial Times calculated that, ‘Italy has less than three months to raise the bulk of its remaining annual financing needs — amounting to about €63bn in fresh debt.’

May’s bond crisis already saw Italian government bonds crash, and their interest rates spike.

This could be the biggest default in history

It spooked the Italian market and the newly elected populist politicians. They stopped trying to raise funds as planned and delayed their bond issuance.

Now, with Italian bond yields and spreads back near European sovereign debt crisis highs, they’re running out of time to raise the money. Just when the ECB is going to stop buying copious amounts of their bonds.

Italy’s budget committee president and the Deputy Prime Ministers have already made clear they expect to flout EU rules on how much they want to spend in their October budget.

And as I pointed out above, that would prevent the ECB from rescuing Italian bonds in the market if they lose their investment grade ratings.

The key now is what the ratings agencies will do. And they’re poised. Two were supposed to update their ratings on Italian debt last month. But they delayed their verdict. They’re waiting for ‘better visibility’ on the Italian budget.

On Friday, the third agency Fitch downgraded the outlook on Italian debt to ‘negative’ from ‘stable’, which isn’t quite an official downgrade of the actual credit rating. But it’s a warning of what’s to come.

If the Italians really do propose the budget they’ve promised voters, and the ratings agencies react with downgrades as they’re supposed to, the Italian bond market will return to turmoil.

Investors will begin to worry that another wave of downgrades will leave the ECB powerless to rescue Italian bonds unless the Italian government compromises.

Eventually, I believe the bond bubble will burst. And in Europe, the central bank won’t be allowed to rescue Italy. The biggest default in history looms.

Until next time,

Nick Hubble Signature

Nick Hubble,
For The Daily Reckoning Australia