The Italian 'non-event' could be a EURCHF event

The 10-year risk premium on Italian debt versus German debt plus EURCHF spot indicates a fair value of 1.15 for EURCHF (source: Bloomberg):

Our idea? Sell EURCHF at 1.1815 with a stop-loss at 1.2010.

Why?

• The uncertainty of the new Italian government's commitment to Europe and the euro.
• The fiscal expansion risk downgrade, higher spreads, and more uncertainty.
• EURCHF correlates well with risk premium on Italian debt in the 10-year (10-year Italy government yield minus 10-year German yield).
• EURCHF has broken down on our long-term monthly model, which uses the 12-month simple moving average (long above, short below).

EURCHF spot versus 12-month SMA – our model is now negative EURCHF:


The Italian situation remains uncertain. The latest news indicate that Luigi Di Maio, Five Star, and Matteo Salvini of League will meet today to finalise their programme before presenting it to President Sergio Mattarella before or on Monday. There is this some degree of “event risk” over this weekend.

It seems unlikely that either Di Maio or Salvini will be prime minister (although Five Star still put Di Maio forward...).

According to Politico, the leading candidates are:

   • 'Mr. Wolf': Alfonso Bonafede is a Five Star parliamentarian whose name has been floated in Italian media for two days as a potential PM. A close ally of movement leader Di Maio, the 42-year-old Sicilian is a lawyer by training and has built a reputation for being a problem solver, hence the nickname “Mr. Wolf” – a reference to Harvey Keitel's brusque-but-effective fixer in Quentin Tarantino’s Pulp Fiction.

   • The shadow man: Vincenzo Spadafora is described by Italian media as the éminence grise of the movement, the kingmaker quietly working behind the scenes. The 44-year-old Neapolitan began his political career in 1998 serving in several left and centre-left administrations. He already has an autobiography called “The Third Italy: A Manifesto For A Country That Does Not Hold Back".

A quick summary of The Five Star Movement and Lega's published programme (sourced primarily from Goldman Sachs' "European Views: an Italian fiscal expansion"):

• Universal minimum guaranteed income to all citizens (cost: €15-30 billion or 1-2% of GDP).
• Reform of tax system (cost: €64bn EUR or 3.7% of GDP).
• Reform of pension system (cost: €15-20bn or 1-1.5% of GDP).
• Cancelling of VAT hikes in 2019, 2021, 2022 (cost: €12.5-19bn or 0.7%-1.1% of GDP).

This fiscal expansion will off-sett a long-term commitment to debt reduction, will most likely put Italy in opposition to the European Union and the European Central Bank, and will risk a downgrade of the country's debt. Even a watered-down version of this programme would be unsettling; the market is slowly repricing risk, but in our estimation is doing so too slowly.

The macro situation is poor in Italy, which is one of just a few countries in the world not yet back at its pre-crisis GDP.

Italian GDP per capita:

Here is the 30-day volatility chart for Italian bond futures, now back to long-term levels (source: Bloomberg):

Here is the Italy/Germany 10-year spread: