Remember when investors used to think German debt was riskier than Italian debt?
Bank of America Merrill Lynch does:
Between 1995 and 2000, Italy’s public debt was 118ppt of GDP, 63ppt higher than Germany’s. However, the real interest rate differential between 10-year Italian and German government bonds was negative, signaling that investors considered German bonds riskier than Italian bonds. History has proved that this was a mispricing of risk. It is unlikely that we will return to that environment. Even though, as the economic outlook improves, it is possible that risk aversion will decline and peripheral European countries will be perceived as less risky than they are today, differences in fiscal fundamentals are likely to keep playing an important role in determining spreads differentials in the future.
“It is unlikely that we will return to that environment” — no kidding.
In fact, Bank of America Merrill Lynch reckons Italy is now heading towards a Greek-like place:
Italy appears on a crisis path, in our view. In the last two days, Italy’s borrowing spreads over Germany’s have increased at a pace that compares with the previous crisis episodes in the Eurozone periphery (Chart 1). Although Italy is projected to eliminate its primary deficit this year, its debt-to-GDP ratio is the highest in the Eurozone after Greece’s and its growth outlook is dismal. At this pace, Italy’s borrowing costs could reach levels that would make its debt dynamics unsustainable in a week (Chart 2). Spain has a higher interest rate threshold for debt sustainability, but the latest trend of rising borrowing costs is also of concern.
From safer-than-Germany to a certified eurozone peripheral in three years, and from eurozone peripheral with decent debt dynamics to totally-doomed in seven days. Things are changing swiftly.
(It could be worth stepping back here, to wonder why the market seems to suddenly ‘wake up’ to certain hotspots. But to be honest, we don’t have the answers. Though we would argue that much of the ‘who’s next?‘ mentality that we saw in the 2008 financial crisis, and the eurozone debt saga, stems from behaviour seen in the East Asian crisis of the 1990s. Perhaps we should read Panic! again…)
In any case, here’s BofAML’s Athanasios Vamvakidis with some more panic-worthy comment:
We have recently argued that Italy is too big to fail and too big to bail out. It is the third largest bond market in the world, after Japan and the US, although with a big difference (Chart 4). Foreign bank claims to Italy are also much higher than to the rest of the region (Chart 5). Funding pressures in Italy, and even more so a sovereign crisis, would have systemic implications, in our view, that would extend well beyond the Eurozone … Given Italy’s systemic implications, not just for Europe but for the global economy, a further deterioration in its bond market could be a threat to the global recovery and even lead to tail risk scenarios for global financial markets. For this to happen, Italy’s borrowing costs do not necessarily need to reach the threshold that would make its debt dynamics unsustainable. It is very likely that the shock would be transmitted to the rest of the world earlier, such as through an increase in global risk aversion. Markets appear to currently underestimate such risks. Volatility remains low, particularly compared with the market turmoil that followed the collapse of Lehman Bothers in late 2008 and the crisis in Greece in the spring of 2010 (Chart 6) …
Interesting times.
Related links:
The Italian panic — rationalisation del giorno - FT Alphaville
Italy as the single point of failure – FT Alphavill