The technicalities of the Italian election are not important, in my opinion, because they don’t accurately characterize the reason why Italians are voting. They want change and reforms to their government; however, they don’t trust the current system run by bankers and politicians. Because the “No” vote is for the status quo and the replacement of Matteo Renzi will not be someone who issues change, the frustration of the people will only accelerate. The polls are currently in a blackout period to make sure the election isn’t influenced. If “No” wins by a wide margin and new polls show the majority of Italians are in favor of leaving the EU, I think a referendum must take place next year regardless of the technicalities. It will be a mandate for a referendum vote.
The chart below shows the difference between the 10-year German Bund yield and the Italian 10 year BTP Yield. The difference represents the political risk seen in Italy. With rate rising, I think the “No” vote is much more priced in than the Brexit or the Trump election. Once the “No” vote wins, there may be a reversal in Italy’s bonds. This would be an example of the ‘sell the rumor, buy the news’ event. I have a higher confidence in this taking place than I normally would because the ECB will be on the front lines buying Italian bonds to make sure selling doesn’t get out of control. We are still in the period where central bank actions can calm markets. This isn’t always going to be the case as I doubt the volatility caused by Italy leaving the EU will be able to solved by ECB asset buying. Obviously, there’s also the case of there being a limited number of assets to buy. If the central banks buy when there’s uncertainty and never collectively sell the assets, this strategy is unsustainable.
The chart below shows the 3 central banks’ balance sheets. Will a “No” vote cause an acceleration of the expansion of their balance sheets? I think so. Every event that causes volatility threatens to be the last one the central banks can solve with debt monetization. Therefore, this round of central bank buying may possibly be the straw that breaks the camel’s back in terms of this unsustainable policy initiative. Political risk is causing the current instability. Given central banks are part of the government, I wonder when the people’s ire aims at them. At that point the jig will be up.
The other reason why this election is critical besides the political risk of Italy leaving the EU, is the fragility of the Italian banking system. Even without the political uncertainty, the Italian banks are in deep trouble. The stocks of the country’s top 12 banks have fallen 8% in the past 3 months on average. The bank in the biggest trouble, Monte Dei Pasci, is planning to issue shares and get rid of $27.7 million in bad loans. Getting rid of bad loans is only masking the symptoms of a larger problem. Management needs to change and the economy needs to improve for the bank to be sustainable. Going through with these emergency measures during a period after “No” wins the election is the equivalent of providing mouth to mouth resuscitation in the middle of a storm. It won’t be easy. The ECB will have to step in to calm markets. It is a ‘distinction without a difference’ for the ECB to calm markets, but not allow taxpayers to fund a bailout of these troubled banks. Money printing devalues the Euro currency. It’s easier to execute without populist backlash because it isn’t immediately noticeable to the European people.
Monet Dei Paschi has received $4 billion in tax payer bailouts and $8 billion in investor money since 2009. It never seems to be enough to quell the problems. It is like trying to plug a sinking ship’s holes with gum. The gum doesn’t plug the hole and new holes keep appearing. The relative problems Paschi has over the other Italian banks is the result of bad management. The fact Italian banks have more bad loans than other European countries is evidence of the systemic growth problems of the country. As you can see from the chart below, the Italian banks’ non-performing loan ratio is over double the European average. The reforms Renzi is proposing would try to solve the banks’ woes, but the Italian people do not trust the bankers to help fix the problems. It’s a powerful message that the Italian people are screaming as they are acting against their short term personal interest of having a sound banking system to get rid of those in charge of it. It shows how long the woes have gone on. An emergency solution doesn’t appear to an emergency if it goes on for years.
I’ve made it obvious that I think Italy will vote “No” in this election. The chart below shows the implied volatility of the Euro/USD showing the possible market reaction could be similar to the Brexit. It is somewhat amazing to recognize that a vote on an Italian referendum which determines how its government will be run has international importance similar to the Brexit. The only reason it does is the possibility of an Italeave. The mere increased possibility of Italy leaving the EU has the same implied volatility of Brexit because Italy going through with leaving has much bigger consequences. Just like how Matteo Renzi as changed his mind about how he will react to the referendum vote, there will be politicians trying to support the narrative that the EU is fine, but this ‘out of touch’ narrative will only provide fuel to the populism.
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