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Here's how Europe's debt crisis will affect you

It sounds strange, doesn’t it? The idea that you could actually benefit from the next financial panic?

Rather than trying to force some elaborate analysis piece down your throat, I’m just going to serve it to you straight up here:

A debt crisis originating from Italy, would send investors fleeing to the United States (most probably to buy up long term US bonds). So, US long-term interest rates would fall. Bond prices move inversely to yields or interest rates.

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Australian banks happen to source funds for fixed interest loans from US long-term debt markets. So, if the cost of doing that is less, there’s every chance they’ll pass that saving onto customers.

That means lower borrowing costs.

Now, if you’re still with me, and you want to know how or why this is the case, please read on!

Markets are nervous about Italy

Global financial markets have been a little volatile of late.

Mid-way through last week investors freaked out in Europe. Banking stocks were sold off, the euro fell, and investors dumped bonds… all at the prospect of a euro-sceptic government forming in Italy.

There were also major concerns that the minster put forward to run the economy would single-handedly drive Italy out of the eurozone.

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The rise of the two popular parties in Italy — the Five Star movement and the League (who are kinda anti eurozone) — has triggered fears of another Greek-style debt crisis, and the possibility of Italy leaving the eurozone.

That’s why banking stocks were sold off AND bonds. That’s because bonds issued by a government that has trouble paying its bills, or by banks whose value is plummeting is not the smartest move.

Potential for a new debt crisis

So I mentioned above “government that has trouble paying its bills” – kind of big statement, hey? Well it’s a distinct possibility.

Despite assurances to the contrary, there are fears a Five Star-led government may blow the current budget deficit out even more than it is now. It’s a populist policy and obviously a bad policy.

The other issue, of course, is the debt load that Italy is carrying. It stands at 130 per cent of GDP. That’s a lot.

Other countries do have similarly eye-watering levels of debt, but Italy is in a unique position.

That’s partly because an Italian default could not be contained. It would spread like wildfire throughout Europe and then across the globe.

Italy versus Greece and “Grexit”

Does all of this remind you of the Grexit days?

Italy is currently a lot better off than Greece was back in 2012 (the latest similar example). Its economy is actually growing and there are fewer systemic issues.

If anything, it’s Italy’s politics, rather than fundamental flaws in its economy, that are causing the current nervousness around its stability.

Greece faced nearly a decade in an economic depression.

Austerity measures have also meant it’s almost impossible for those on basic wages to ever get ahead in life or increase their wealth.

It’s been an economic crisis of epic proportions. But Greece was never booted out of the eurozone… and Italy’s not even close to where Greece was during that time.

Italy’s current political landscape, if it continues to push interest rates higher and drag the stock market down, has the potential to seriously slow the economy, rather than send it into a recession.

That is, of course, if the political dramas don’t escalate further.

Money managers are genuinely nervous

What money managers around the world are worrying about is if the new Italian coalition will be vocal about wanting to leave the eurozone.

That, says investment firm QIC’s lead researcher Katrina King, would lead to a possible run on international banks.

“We’ve seen it a little bit in credit markets, certainly in Italy with Italian banks, but moving into other European banks as well, that’s moved to European credit generally,” she said.

“I would say for now, though, we really haven’t seen it target US, and certainly Australian credit, but that would be something to watch for.

“I think we are alert and aware to a contagion brewing, certainly it’s become more of a contagion throughout Europe.

“The market has really jumped on perhaps a bandwagon of ‘is this a growing probability of Italy leaving the euro?’

“It’s something that we’re going to continue to watch as this populism gains momentum.”

Italexit?

So, what about those worries about Italy actually having to leave the eurozone because of all of this?

Well there are legitimate concerns a euro-sceptic coalition would move the country closer to leaving the euro.

Is that really a possibility?

At this point the narrative gets a little confusing.

At the start of last week, traders on financial markets were freaking out because it seemed possible that the caretaker prime minister would only last a month or two, and would be followed by an election that could see fiercely anti-establishment politicians rise to power in Italy.

And, no, freaking out isn’t too strong a phrase.

Some Italian bond yields rose by the most in 26 years, a sign of genuine investor fear.

Investors were seen fleeing to what are deemed to be ‘safe haven’ securities like US debt.

Indeed the price of the 10-year US Treasury bond shot up, sending the yield down below 2.8 per cent. Bond prices move inversely to yields.

But later in the week they backtracked, despite the Italian president leaving the door open for the euro-sceptic coalition to form government.

The sense from political and economic analysts was that the market was craving some political stability in the short term and that’s what it got. There were also reassurances from the European Central Bank that a crisis was not imminent – but of course it would say that.

Now, the populist coalition has officially formed government, and the economy ministry is no longer in the hands of a euro-sceptic… all’s well, right?

Assuming the possibility of a euro-sceptic ruling coalition in Italy remains, I suspect markets will stay on edge.

German-born, New Zealand-based economist Oliver Hartwich is certainly concerned.

“I would argue if Italy ever leaves the eurozone it will probably be the end of the European Union,” he said.

“There is every chance the markets will become more and more nervous.

“You can see that in markets over the past few days — markets pricing in the possibility of an Italian default, which only a few months ago nobody would have thought thinkable.”

He argues all of this political uncertainty has the potential to create some jitters in the market and “we’re only seeing the first waves of that now.”

Interest rates could stay lower on euro jitters

Back to what this means for Australia, it does have the potential to be a positive.

That’s because European bond investors this week have dumped Italian bonds and run to the safe haven of the US debt market.

As mentioned before, when bond prices rise, the interest rates on those bonds falls.

So, as investors have bid up the prices of US bonds, the yields have fallen. That includes the yield on the US 10-year Treasury bond, a key benchmark for Australian fixed-rate mortgages.

If the US 10-year bond yield remains under pressure, there’s less chance of Australian fixed-rate mortgages rising.

Will they in fact fall? Let’s not get ahead of ourselves.

I suspect there’s more drama to come in Italian politics, in which case global markets will continue to be volatile.

 

@DaveTaylorNews