Italy And “Ro, Ro”
Commentary and weekly watch by Doug Noland
Last week saw a relatively quiet Monday, with the Dow flirting with all-time highs. Initial reports from the Italian election had the front-running coalition, led by Pier Luigi Bersani, coasting to victory. Italian 10-year bonds were rallying sharply, with yields sinking as much as 27 basis points to 4.17%. The euro was gaining about 1%, trading above 1.33 versus the dollar and above 125 against the yen. Basically, it was business as usual for highly speculative global markets, as the bulls chuckled ”told you so!” That is, before all hell about broke loose in the currencies.
Various exit poll projections began painting a quite different picture of what had transpired with Italy’s electorate. The presumptive prime minister’s (Bersani) left-leaning coalition was not receiving the expected support. Instead, the big election surprise was the strong performance of comedian Beppe Grillo’s Five Start Movement. Worse yet, Silvio Berlusconi, the disgraced former prime minister not long ago given up for dead, was proving himself the cagey cat with nine lives. His right-leaning coalition was doing better-than-expected, with a chance to deny Bersani (perhaps even in alliance with Monti) a majority in Italy’s Senate.
And, perhaps worst of all for European leaders and the markets, Caretaker Prime Minister Mario Monti’s coalition was looking like an election disaster. It became a distinct possibility that no party would garner sufficient control in the two houses of parliament to appoint a leader for a new Italian government.
Suddenly, complacency gave way to trepidation of a ”hung parliament” and the potential for an ”ungovernable” Italy (the world’s third-largest debtor nation!). At least in the currencies, the reaction was rather swift and ferocious. After trading above 1.330, the euro sank to 1.305 to the dollar by the end of the day. The really stunning move, however, was in the euro/yen. After trading above 125 in the morning, the euro/yen ”cross” traded below 119 by late-afternoon. The yen rallied more than 4% against the euro and, curiously, almost 3% against the dollar.
The Wall Street Journal and others have highlighted the recent big macro hedge fund profits achieved by betting aggressively against the yen. Monday’s Italian election-induced reversal in the yen kicked the yen bears in the teeth. It will now be interesting to see if the yen reversal marks a key inflection point for the global ”risk on” backdrop that has captivated the investing and speculating world in recent months – and provoked ebullient predictions of a new bull market.
So, one might ask, why is the Italian election a big deal for Europe, the euro, the yen, global ”risk on” and the supposed ”new bull” in US US equities? This past summer, the Draghi Plan (Outright Monetary Transactions/OMT) singlehandedly transformed European securities from the leveraged speculating communities’ preferred shorts to their must-have longs. This reversal of speculative finance (”hot money”) dramatically altered financial conditions throughout Europe, while strongly bolstering the flagging euro currency (not to mention confidence in European financial institutions). Importantly, Draghi (with help from the Fed and global central bankers) removed the near-term tail-risk catalyst impeding global ”risk on” – and held a potentially problematic global systemic crisis at bay.
Crisis risk in Europe was viewed as having been taken off the table, while the Fed’s $85 billion monthly QE would also pressure the dollar and generally support speculation and inflating global risk markets (pro-”risk on”). Meanwhile, the new Abe government in Japan was seen supporting radical monetary stimulus to weaken the yen and jumpstart the moribund Japanese economy.
For more than two years, the prospect of a bout of European-induced ”risk off” had bolstered the safe haven appeal of the yen. Now, the big sophisticated ”macro” hedge funds saw their long-awaited opportunity for a big one-way bearish play against Japan’s susceptible currency. The Japanese wanted their currency lower and global risk markets were in a favorable state of ”risk on” that itself created an overhang pressuring the yen (along with other perceived safe havens). At the same time, selling yen to finance higher yielding securities in stronger currencies also worked to bolster global ”risk on.”