Why Draghi Really Cares About Italy
Aside from the fact that he is Italian and once served as governor of the Italian central bank there are other reasons why Mario will be concerned at the price action in Italian Government Bonds (BTPs). Politics aside, as the ECB is not political, it is a rules driven institution and there are monetary policy reasons why the recent spike in Italian yields must be of concern to the ECB.
Firstly, any sustained pick up in BTP yields, particularly at the short end, will result in a breakdown of the transmission mechanism. This is a term that we used to hear at every Mario Draghi press conference, but have not heard for a couple of years now. The transmission mechanism breaks when the intended short term rates are not passed on to the economy. So a spike in short dated BTP yields, if sustained, will result in money coming out of bank deposits and into BTPs at higher yields. This is a very simple trade for corporates or consumers to execute. The result of this would be banks increasing their rates to lure back or maintain their deposits, which in turn would derail Italy’s transmission mechanism.
There is also an “unintended tightening” of monetary policy. Both unintended tightening and breakdowns in transmission mechanisms, if sustained and material enough, would result in a response from the ECB.
With 2 year BTPs having only touched 2% very briefly we do not think that the ECB will be worrying too much yet; as yields have quickly bounced back to below 1% as the political uncertainty has been subdued by market friendly comments from Giovanni Tria, the Finance Minister. However, a bigger and more sustained move would almost certainly drive the ECB to take note and debate action.
As an aside, for Italian depositors, a 2% BTP yield is more attractive than nearly any deposit. For bank treasurers around Europe who can repo these into the ECB it is also a great carry trade, and for $ investors when these 2 year BTPs are swapped back to $ the yield is close to 5%. From our perspective it is no surprise that yields bounced so hard.
Firstly, any sustained pick up in BTP yields, particularly at the short end, will result in a breakdown of the transmission mechanism. This is a term that we used to hear at every Mario Draghi press conference, but have not heard for a couple of years now. The transmission mechanism breaks when the intended short term rates are not passed on to the economy. So a spike in short dated BTP yields, if sustained, will result in money coming out of bank deposits and into BTPs at higher yields. This is a very simple trade for corporates or consumers to execute. The result of this would be banks increasing their rates to lure back or maintain their deposits, which in turn would derail Italy’s transmission mechanism.
There is also an “unintended tightening” of monetary policy. Both unintended tightening and breakdowns in transmission mechanisms, if sustained and material enough, would result in a response from the ECB.
With 2 year BTPs having only touched 2% very briefly we do not think that the ECB will be worrying too much yet; as yields have quickly bounced back to below 1% as the political uncertainty has been subdued by market friendly comments from Giovanni Tria, the Finance Minister. However, a bigger and more sustained move would almost certainly drive the ECB to take note and debate action.
As an aside, for Italian depositors, a 2% BTP yield is more attractive than nearly any deposit. For bank treasurers around Europe who can repo these into the ECB it is also a great carry trade, and for $ investors when these 2 year BTPs are swapped back to $ the yield is close to 5%. From our perspective it is no surprise that yields bounced so hard.
