Italian Default is Back on the Menu

Italian Deputy Prime Minister Matteo Salvini was right to call out the EU over the failure of the bridge in Genoa this week. It was an act of cheap political grandstanding but one that ultimately rings very true.

It’s a perfect moment to shake people out of their complacency as to the real costs of giving up one’s financial sovereignty to someone else, in this case the Troika — European Commission, ECB and IMF.

Italy is slowly strangling to death thanks to the euro. There is no other way to describe what is happening. It’s populist coalition government understands the fundamental problems but, politically, is hamstrung to address them head on.

The political will simply isn’t there to make the break needed to put Italy truly back on the right path, i.e. leave the euro. But, as the government is set to clash with Brussels over their proposed budget the issues with the euro may come into sharper focus.

Looking at the budget it is two or three steps in the right direction — lower, flat income tax rate, not raising the VAT — but also a step or two in the wrong direction — universal income.

Opening up Italy’s markets and lowering taxpayers’ burdens is the path to sustainable, organic growth, but that is not the purpose of IMF-style austerity. It’s purpose is to do exactly what it is doing, strangling Italy to death and extracting the wealth and spirit out of the local population, c.f. Greece and before that Russia in the 1990’s.

So, looking at the situation today as the spat between Turkey and the U.S. escalates, it is obvious that Italy is in the crosshairs of any contagion effects into Europe’s banking system.

As Martin Armstrong points out European banks, especially Spanish, Italian and Portuguese banks, loaded up on Turkish corporate debt paying insane coupons because of the financial repression occurring within the euro-zone.

As central banks pumped money into the system over the past decade, nations like Turkey and other emerging market economies used the opportunity to raise more and more “cheap” debt to boost their productivity. Turkey has attracted capital from Europe seeking higher yields because of the negative interest rates policy of the ECB. Now we have a crisis in Turkey that is also the result of Draghi’s Quantitative Easing that drove capital to Turkey and FAILED to revived the European economy.

How big is the problem?

Well, (H/T to TraderStef for the link) according to Morningstar:

The European Central Bank is reportedly concerned over the health of southern European banks, which have lent large amounts of money to Turkey. According to the Bank of International Settlements, Spanish banks hold $83.3 billion of Turkish debt, French banks hold $38.4 billion and Italian banks hold $17 billion.

That’s more than enough to become a real concern for everyone especially since ECB President and VP of Propaganda, Mario Draghi, keeps telling everyone he’s going to stop buying EU sovereign debt before the end of the year.

But, we all know that the ECB has been the only marginal buyer of Italian sovereign debt for months. Moreover, as Zerohedge points out Italian banks have begun buying Italian sovereign debt in what is known as the Debt Doom Loop —

This vicious circle of Country X banks (in this case Italy) buying Country X bonds during times of stress – with the backstop of the ECB – has for years been Europe’s dreaded sovereign bank doom loop. And, as Italy clearly demonstrated, repeated and aggressive attempts by European regulators and policymakers to finally break the doom loop, most recently with the introduction of the 2014 BRRD directive, which sought which sought to remove the need for and possibility of bank bailouts, and instead ushered in bail ins, have been an abject failure.

It is also a major problem.

Ya think?

So, amidst insane levels of bond market intervention by regulators of all stripes, a geopolitical spat between Turkey and the U.S. over Turkey’s obvious desire to leave the strictures of the West behind is blowing back hard on Europe as dollar liquidity gets scarce.

Is it any wonder that the sell off in Italian debt which the ECB got under control in the early weeks of the new Italian government, began again, the minute Italy’s budget plan was revealed.

And now that sell off is accelerating again as funding pressures on Italian banks has likely curtailed their buying Italy’s sovereign debt.

The middle of Italy’s yield curve is moving the fastest, with the 5 year note up nearly a full point in just 4 weeks. 3 month yields are creeping back up towards positive, against the ECB’s wishes.

Moreover, this weakness has spread to the euro, which has broken down below strong support at $1.15 and is now looking at $1.10 or lower.

Neither Turkey nor the U.S. seem capable of backing down at this point. And that spells real trouble for Europe and, in particular, Italy.

The U.S. just announced another round of sanctions as the Treasury department and the Office of Foreign Asset Control uses the only tool it has, a hammer.

And anyone getting off the IMF-debt slavery cycle looks like a nail.

I discussed this in my last blog post.

Erdogan, for his part, has all but accused the U.S. of having staged the 2016 coup attempt against him. His lawyers are pressing for a questioning U.S. military personnel stationed at Incerlik.
If the next step in the financial war is to threaten Turkey with SWIFT expulsion over doing business with Iran, then Turkey’s next move could be to raid Incerlik and extract those Erdogan believes to be guilty of organizing the coup.
Both of these are nuclear options, and if one is on the table, then the other is as well.
And that’s when the chest thumping ends and someone gets his nose bloodied.

The U.S. just said that even if Pastor Brunson is returned, the sanctions will stay in place. So, what would be Erdogan’s incentive here to give in, exactly?

So, remember the situation, Turkey has leverage over Europe because of the debt load while the U.S. has leverage via the currency the debt is denominated in.

But, ultimately, once rates start to rise in Europe, we’re going to find out that Draghi at the ECB has no other choice but to keep buying debt or allow rates to explode to the upside.

This is why this situation is so important and the stalemate between the U.S. and Turkey so potentially explosive. This is especially true if Russia and China stand ready to assist Turkey in debt swaps while leaving EU banks exposed.

So, for Italy, the same thing applies. They have leverage in their upcoming wrangling with the EU over its budget. The Genoa bridge collapse is an emotional event that can easily be used by Salvini and company to push Germany, in particular, over structural reforms which loosen the Troika’s control over EU-member states.

And if the EU doesn’t budge, then it will be a much easier sell to say ciao. Because once this turns into a chaotic rout all bets are off. And Salvini can sell independence from the EU as a matter of national pride.