Week in Review
News of political uncertainty in Italy, trade disputes and a strong employment number for May injected volatility into the U.S. stock market, with the S&P 500 ending up .43 percent for the week and U.S. Treasury bond prices moving higher, with the yield on the 10-year bond ending the week at 2.89 percent.
As the third largest debtor country in the world, Italy (and therefore its political stability), matter to global capital markets. What caught the attention of the financial markets was the spike in bond yields for Italian government debt. Specifically, the yield on the Italian 2-year government spiked from .30 percent to 2.76 percent in the span of three days this week. While a 2-year government bond trading at 2.76 percent is nothing to panic about, the rapid increase in Italian 2-year yields, certainly caused concern.
On Monday, Italian president Sergio Mattarella declined to appoint a presumed Eurosceptic candidate for finance minister. This candidate was proposed by the League and Five Star Movement, who are populist parties that have been gaining increased power in the Italian government. However, by the end of the week a populist coalition government had been installed, although a vote of confidence is still required by both houses of parliament. This development removed the risk for snap elections later this summer, which could have resulted in an increase in populist party power and therefore had EU-supporting investors worried.
Populism in Italy is often associated with being anti-euro. If Italy were to exit the European Union, it could be problematic not only for the EU but also for the world economy. Presently, outstanding Italian government debt stands at 2.5 trillion euros. If Italy were to exit, it would need to adopt a new currency, speculated to be the "new lira". On a stand-alone basis, a "new lira" would most likely drop in value relative to the euro. Italy would then be forced to repay its €2.5 trillion debt in lire, which would become more expensive due to the theoretical decline in the value of the new currency. Additionally, Italian citizens are not prohibited from having bank accounts in other countries. Any sense that Italy’s currency might change could result in a mass outflow of deposits from Italian banks. In general, it is better to have your debts and income denominated in the same currency as an individual or a country.
Takeaways for the Week
In general, populism is growing in Italy and Europe. While a low probability event, Italy leaving the European Union and the euro currency would potentially have severe consequences
The U.S. Economy continues to be strong with 223,000 jobs created in May and the unemployment rate now at a 50-year low of 3.8 percent