By Andreas Steno Larsen and Martin Enlund, e-markets.nordea.com
Italian turmoil has hit European risk appetite this week, while Chair Powell once again lifted US bond yields. The 10yr treasury yield now trades around 3.20% – a substantial break of the post-1984 downtrend. Global risk appetite is at a cross roads.
Italian headlines have filled up most of the news flow this week, as DAX underperformed S&P 500 (again). It is no wonder that markets are getting concerned about Italy given how “Erdoganish” Luigi Di Maio from the Five Start Movement has sounded in recent weeks. Subsequently the 10yr Italian bond yield has returned to more normalized levels above 3.30% (Italian bond yields have been too low for years), but with the current pace of the Italian bond sell-off, it won’t take long until Italian debt reaches unsustainable territory.
It’s concession time, ItalyAfter the big moves in the Italian bond yields Friday last week and Monday this week, there have been some early tentative signs that the Italian party leaders Luigi Di Maio and Matteo Salvini will soften the confrontational stance a little. Even though Di Maio and Salvini will never publicly admit it, they are forced to dance to the market’s tune to a certain extent. In May, they moved swiftly to put a lid on the “Italeave” discussion as the rapid Italian bond sell-off forced them to think twice.
So far, the concessions from Italy surround the budget targets for 2020 and 2021. The 2019 proposal of a 2.4% deficit seems carved in stone. Concessions on the 2019 target are needed as well, before the market and Brussels will take material comfort in the slightly more conciliatory tone. The markets have heard the “We will deliver next year” phrase too many times from the Italians to really trust it. Results are needed now, not later.
Continuing down the initial confrontational path would be suicidal; therefore, Di Maio and Salvini will start dancing to the market’s tune sooner or later. The big question is whether it will be in time to avoid a downgrade in S&P and Moody’s rating reviews later in October. Overall, we judge that if Italy will be downgraded later this month, markets will have traded on that story already.
Table1: Important key dates are still ahead for the Italian budget for 2019
Since Feb-2015 the only “funding source” of the Italian deficit has been Banca D’Italia/ECB (no other source has net bought Italian debt since Feb-15), so who will fund the increased deficit plans, when the ECB stops the net purchases of government debt in the QE programme at new year? The short answer is domestic Italian banks. Exactly as they did during the debt crisis in 2011-2012 (see chart 1). It is hard to see how that can fly without a further sell-off in BTPs, why Di Maio and Salvini need to take the recent market reaction very seriously. Had it been in the spring next year (without the ECB underpinning markets with purchases), it would have been even more dramatic.
In our models, Italy’s debt is roughly sustainable as long as the average bond yield doesn’t exceed 3.8% (we are still some 70-100bps from that), but a country with as big a debt burden as Italy ought to have a substantial buffer in case of shocks. That buffer is getting worryingly small.
Chart 1: Who will fund the Italian deficit, when the ECB “exits”. Most likely domestic banks as in 2011-2012
In the meanwhile, most forward-looking indicators for Italy (and for the Euro area in general) still point south, albeit not dramatically. If i) Italian PMIs drop below or close to 50 (as the leading versus lagging components of the Euro area PMI indicate), ii) the ECB stops net purchases at year-end and iii) Di Maio/Salvini don’t change course, then Italian markets risk facing a Siberian winter rather than an Italian spring when the calendar writes 2019.
Di Maio and Salvini still have time to soften up and sooner not later Di Maio and Salvini will start dancing to the market’s tune. After all, Italy is not Turkey, why there is a fair chance that calm will be restored.
Chart 2: Downside risks for Italian PMIs are material
Widening Italian spreads have been a factor behind the re-weakening of the EUR against the USD, but if the Italy story had been the primary driver, we would have expected EUR/CHF to trade lower as well. EUR/USD has also dropped due to hawkish Fed signals and year-turn effects in the USD rates space.
Chart 3: Higher EUR/CHF and lower EUR/USD tells us that Italy is not the primary reason for lower EUR/USD
Risk appetite is at a crossroad
Italy woes are though not the only headwinds facing global risk appetite. Recently small caps have sold off compared to large caps – and one potential trigger for that is likely the recent re-signing of NAFTA between US and Canada. Small caps (more domestically based) have performed relatively to large caps (more vulnerable to international trade) when NAFTA tensions were the highest – now that the trade roadblock is cleared in that regards, small cap underperform again.
This is though the rosy version of the story. The post September sell-off in small caps globally could also be seen as an early signal that the growth momentum is slowing and that investors are moving inwards on the risk curve consequently. We also argue that small caps are often associated with the kind growth style, which is the most vulnerable to the rising interest rates that we are witnessing. In general, small caps also have a higher proportion of their cost base in labour and with wage costs on the rise earnings estimate risks should hence be greater in small caps versus large caps. Finally, it’s worth remembering that small caps carry greater liquidity risk now that central banks start reducing excess liquidity. We subscribe to a combination of these explanations.
Chart 4: More NAFTA stories, better relative small cap performance and vice versa
On Wednesday, Fed Chair Powell once again confirmed the hawkish stance by hinting that the Fed “may go above neutral” in the Fed Funds (currently the dot plot indicates a neutral nominal rate at 3% in the dot plot). Powell comments were the final trigger that allowed the 10yr treasury yield to take off compared to the long-term assessment of the Fed Funds rate in the dot plot. Clearing this hurdle in principle leaves the door wide open to further upside for the 10yr treasury yield (the strong ISM composite figure from this week indicates a 3.25-3.50% range next up) – this also leaves the possibility of a temporary re-steepening of the curve elevated in to year-end.
Chart 5: The 10yr treasury yield has now cleared the long-term dot plot hurdle
A break on the top side of the 3.12% level in the 10yr treasury yield, as we have seen this week, will also reignite the discussion whether the break of the post-1984 downtrend in the 10yr treasury yield is a signal to worry about for risky assets. Every major test of the post 1984-downtrend has coincided with a subsequent turbulent period in S&P 500. Will history rhyme again, now that the trend is not just tested, but broken? We keep a negative tilt for risky assets.
Our story that the US vs. Rest-of-World outperformance is suffering from mental fatigue currently hinges more on the valuation aspect (US equity valuations are very stretched) than the relative macro picture.
Chart 6: Every major test of the post 1984 downtrend in the 10yr treasury yield has coincide with turbulence in S&P 500
What is most important in the week ahead?
We have a big inflation week ahead of us. Both in the US, Norway and Sweden the monthly inflation figures are published with potential important bearing for the monetary policy outlooks.
On Thursday, US inflation is out and it will be interesting to see whether the weaker-than-anticipated inflation from August will slide further. We expect a rebound from 2.2% to 2.3% in the core inflation measure in September with roughly balanced risks. However, we don’t see big risks of a sharper acceleration in US core inflation on this side of new year due to the sharp rise in productivity in Q2 (with all the uncertainties surrounding such measure) that kept unit labour costs relatively subdued (productivity adjusted wage growth), among other things. Should US core inflation fade a little towards new year, we don’t see it as a big game changer for the Fed, as they have recently started citing financial excess as another reason to continue quarterly rate hikes.
Chart 7: US core inflation will not accelerate further on this side of 2019. Expect 2.3% in September
After a light news week in Scandinavia, inflation data are out from Norway and Sweden on Wednesday and Thursday, respectively. We forecast Norwegian core inflation at 1.8% in September (Norway inflation preview: Was the August rise temporary?), above Norges Bank’s view of 1.6%. The 1.9% core inflation (CPI-ATE) was not fully discounted in Norges Bank’s rate path in September, as they viewed the 1.9% reading as temporarily high. This month’s figure is thus a litmus test of that view from Norges Bank. We bet that they will be hawkishly surprised.
In Sweden the inflation figure on Thursday is kind of a make or break it data point for the potential Riksbank hike in December. Last week the important deputy governor Per Jansson pre-warned that a rebound in Swedish core inflation (and service inflation in particular) is a prerequisite for a tighter Swedish monetary policy. On average September has been a month when the consensus has been negatively surprised by the actual CPIF price growth in Sweden. Estimates have on average been roughly 0.15 percentage points too high since 2009 and even more so in the last two consecutive years.
Nordea sees CPIF inflation at 2.3% (1.5% in CPIF ex. energy) in Sweden on Wednesday. Our forecasts are below the Riksbank’s view. In addition, the risks to our forecast are on the downside. (Swedish September CPIF preview: Risks on the downside).
We keep our more positive view on NOK compared to SEK intact as a consequence.
Chart 8: Consensus expectations are usually too high in September for Swedish inflation
Lastly, we need to keep a watchful eye on the ECB’s monetary policy account on Thursday. Usually it is not a market mover, but it could be this time around, if early discussions on the reinvestment programme next year are revealed. Recently rumours surrounding a potential operation twist (buying more long-dated bonds in exchange for less ownership of shorter running bonds) have swirled. More clarity on a potential operation twist could help calm markets surrounding Italian debt.
Editorial by Senior Global Strategist, Andreas Steno Larsen
Key research pieces over the past week:
FX weekly: Along came year-end (30 September)
NOK: How far can you go? (02 October)
EM Traffic Light September 2018 (02 October)
China monthly: Looking beyond the trade war (04 October)
Brazil election: a hope for a lesser evil (04 October)
Table 2: Main releases to watch
The week starts off with a light day on the data front. From Norway we get manufacturing production numbers. The Fed’s Bullard (dove, non-voter) speaks during the day.
Tuesday is also a light day with regard to key events. From Norway we receive monthly GDP data – a new figure which has just recently started to be published. From the US we receive the NFIB Small Business Optimism. The FOMC members Williams (hawk/neutral, voter) and Harker (neutral, non-voter) speak during the day.
Wednesday is a big Scandi inflation day. We receive inflation numbers from both Denmark and Norway, and from Sweden we get unemployment rate. The Fed’s Williams (hawk/neutral, voter) and Evans (dove, non-voter) speak during the day.
Today is filled with interesting releases. From the US, we get inflation figures and the ECB publishes its monetary policy accounts. From Sweden we get inflation figures and housing prices. The Fed’s Bostic (dove, voter) speaks during the day.
On Friday the calendar is light. Final German inflation figures are released, and we receive trade balance numbers from both the US and China, which could prove interesting given the ongoing trade dispute between the two countries. The Fed’s Evans (dove, non-voter) and Bostic (dove, voter) speak during the day.