Political risk is on the rise in the European sovereign debt markets but the ECB’s QE is making it almost invisible. Yet, it is there. One just has to look for it.
Let’s take Italy and France. Both countries are going through political turbulence and the yield spread between Italian 10-year BTPs and German Bunds has recently widened up to 188 bps, its highest level since the start of the Public Sector Purchase Program launched by the European central bank on March 2015.
The same goes for the yield spread between French 10-year OATs and German Bunds, which has recently has gone up to 70 basis points, an unprecedented level since the beginning of QE.
Markets had started to relax on France. They were betting on François Fillon, France’s leading candidate to oppose the populist and extremist anti-euro Marine Le Pen, but the right-wing politician is at pains in the middle of a scandal, having allegedly misused public funds. A political black swan.
Now markets are turning their hopes for French political stability on the centrist Emmanuel Macron building momentum, and just yesterday the OAT/Bund spread shrank a bit just for that. But now it is hovering around the 60 bps area, and this is quite high for French sovereign risk.
For a long time markets have been considering France a proxy of Germany with a OAT/Bund spread stuck in between 10 and 20 bps. But France is no proxy: French debt/GDP is seen going up this year to 98%, getting closer and closer to the psychological threshold of the 100% ratio whilst Germany’s debt/GDP is going down, from a peak of 85% reached during the Great Crisis is heading towards 67% this year. French growth is not spectacular either, around 1.4%.
France is more a proxy of Italy. Italy is experiencing political turbulence too, with weak growth and a high debt/GDP ratio that is not coming down. Italy is struggling to come up with a market-friendly new electoral law that would reach two objectives: to make sure the country would not fall into the hands of the anti-establishment 5 Star Movement and at the same time to guarantee the formation of a solid government with a strong majority in Parliament to implement a tough program of structural reforms in order to enhance growth.
Moreover, Italy has to decide whether it is going to hold snap elections this year or it is holding on to the general elections scheduled on early 2018: BTPs are going to be sold especially by non-resident investors just before the elections, noone is long before elections. The spread BTp/Bund is going to get wider, as it usually happens: the real question is whether the spread is going to widen just temporarily or to stay and get wider after the elections.
On the top of this political uncertainty, Italy’s interim government led by Prime Minister Paolo Gentiloni has to deal with Brussels’ requests to keep its deficit/GDP on target, or close to target, in spite of relevant mitigating factors, in order to reduce its debt/GDP: Italy has to avoid an excessive deficit procedure just now, as this would not please markets. Italy is the biggest sovereign borrower in the euro area: this year its gross issuance program will get close to €450 bn, due to a heavy redemption calendar. And solving some overdue banking problems might send the public debt stock higher too this year.
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