Daily State Of The Markets: Is Italeave The Next Problem?

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Includes: FXA, FXB, FXC, FXE, FXF, FXY, UDN, UUP
by: David Moenning

Summary

Markets freaked out over the potential for another round of the European debt crisis.

And the potential for the collapse of the euro.

But there was more than met the eye going on yesterday.

Well, that was interesting. I don't know about you, but I had a pretty severe case of déjà vu yesterday as the global markets freaked out over the potential for an "Italeave." We've definitely seen this movie before as the European banking crisis dominated the markets from 2010 through 2012, creating meaningful declines for stocks in each year. But, the good news is that in the end, the hero didn't die, and markets moved on.

Maybe it was the jet lag, but I didn't find myself as concerned as I might have been over the latest version of the European banking mess. More likely, it was the fact that this particular freak-out was being sponsored by what could happen in Italy, in Spain, in Portugal, etc. And when you dug into the story, the headlines themselves didn't seem to support the ginormous moves taking place in the bond pits.

The first point to understand is that the move that triggered Monday's selling in Europe wasn't a signal that Italy was preparing to leave the eurozone or even that an "Italeave" was on the table. No, it was the extrapolation of what could come next that caused the concern.

Here's the situation. Italian President Sergio Mattarella has been tasked with forming a government, which, so far at least, hasn't happened. The problem is that the two parties that hold majority of seats in Parliament are anti-euro. But, the two parties have so far agreed to play nice and not band together to form an anti-euro government. Unfortunately though, this also means that President Mattarella isn't likely to be able to get the job done.

This week's drama kicked off with Mattarella saying no to the anti-euro parties' proposed finance minister and putting forth a nominee of his own. This effectively means that a coalition government is not going to happen (a government that would clearly favor an "Italeave") and that elections are likely the next step.

The problem here is that new elections provide an opportunity for populist/anti-euro sentiment to gain momentum - again. As such, the elections are being seen as a referendum on Italy staying in the euro.

Of course, this dredges up all the hand-wringing about the financial implications of an "Italeave." And none of them are good. Italy has a couple trillion in debt held by banks (this is the sticky part) that would face a defacto default if a new currency were formed. This is where the extrapolations and the potential for contagion (i.e. the problem spreading around the globe and putting the banking system at risk) comes in.

Cue the massive selling of Italian bonds, the euro, and associated risk assets, and the buying of so-called safe-haven assets such as U.S. bonds.

The move was eye-opening to say the least as Italy's bonds had their worst day since 1989. The yield on Italy's 10-year went from negative to over 3% in a day and a half while the U.S. 10-year yield dove to 2.768%. (Recall that the yield had been 3.115% on May 17th.)

More Than Meets The Eye

However, it is important to recognize that the U.S. stock market didn't go into freefall mode the minute the opening bell rang Tuesday. No, the move was actually a bit muted and stocks actually rebounded within the first hour. Thus, in the early going, it appeared that traders were taking the Italy worries largely in stride.

But then we got headlines from both Morgan Stanley (NYSE: MS) and JPMorgan (NYSE: JPM) regarding slowing growth in trading and wealth management. That's when the real selling in the banks started.

From there, it was on. The algos pounded the banks unmercifully for several hours and before you could find a second cup of coffee, the day had turned ugly.

Today Is A New Day

The good news this morning is that yesterday's selling is not ongoing in Europe. In fact, most stock markets across the pond are green at the moment. This is likely due to the fact that Italy successfully sold a bunch of bonds at auction today, which suggests that all is not lost at this stage of the game.

The question, of course, is if the calm will continue. You see, there are other matters for traders to fret over on this fine Wednesday such as Trump's commitment to tariffs on China. Apparently, the President has surprised everyone again with a decision to move forward with additional tariffs and sanctions against China - this before the weekend's talks with China.

For me, the key will be the action in the bond markets. However, any/all headlines relating to Italy, Spain, or European banks is bound to attract the attention of the algos. So look alive everyone, because if we learned anything from the European debt crises we went through earlier in the decade, it was that things can change quickly.

Thought For The Day:

Once the game is over, the king and the pawn go back in the same box. -Italian Proverb