Italian Politics: Implications for the Eurozone

  • The new Italian government has a radical agenda involving lower taxes and higher spending, and a more combative attitude towards the EU
  • The proposed programme is likely to make fiscal sustainability concerns worse without any compensating boost to growth
  • We think that ultimately, the ECB will intervene to guarantee Italian solvency, but it is a question of how perilous the situation can become before intervention becomes necessary
  • In the long run, the significant concern is that this makes the politics of Eurozone reform very difficult. If the banking union is not completed and some form of common fiscal policy not achieved, the Eurozone will remain severely exposed to any economic risk as it was in the aftermath of the global financial crisis

With their respective memberships overwhelmingly backing the proposed joint programme in plebiscites over the weekend, a coalition between the Five Star Movement and League seems all but inevitable. Fears of a populist takeover of a major European economy have finally been realised. The Eurozone’s fourth largest economy now has a leadership openly hostile to the concept of the euro. In this blog post, we analyse the short-run and long-run implications of this for financial markets and the survival of the euro.

The coalition programme

From an economic perspective, the key things which made it into the final programme are:

  • A version of a “flat tax”, as per League’s manifesto, with a 15% and 20% rate.
  • A guaranteed income of €780 per month for poor jobseekers (the so-called “citizen’s income” which is a highly watered-down form of Universal Basic Income)
  • A pledge not to raise VAT (as would happen automatically in the Autumn budget without intervention)
  • Rolling back pension reform made under Renzi to raise the retirement age to 67
  • Their policy on the euro is apparently “still under discussion”

Naturally, there are a number of implications for the Italian economy from such a radical programme. A caveat to the following is that the new government will have a relatively small majority (six) in the Senate. In particular, the aspects which are not common to both parties’ manifestos may not clear the legislature if party discipline is weak. On the other hand, brokering deals over the tax rises and spending cuts potentially required to balance the national budget may be difficult.

Fiscal sustainability

Between the Citizen’s income, the flat tax and the pension reform, the cost is estimated at around EUR100bn per year, or 5% of GDP. Given sluggish Italian growth and a large outstanding debt stock, this could imperil Italy’s fiscal sustainability. This is illustrated in Figure 1, which projects the debt-GDP ratio under the assumptions of a balanced budget, and the new government’s proposed spending plans. Naturally, this does not take into account the growth effects of the spending commitments but these are unlikely to change the picture significantly. The growth effects of League’s tax reform are highly uncertain, but most reasonable estimates of revenue-maximising tax rates would put them higher than 15%. Furthermore, for the growth effect of these reforms to lead to a neutral effect on the debt-GDP ratio, a 24% expansion of GDP would be required. There are also few proposals in the programme which look likely to raise Italy’s chronically anaemic productivity growth. In theory, the biggest risk here is not necessarily one of insolvency, provided the ECB continues to act as lender of last resort, although political pressure may prevent this function from being fully exercised. However, it increases the likelihood of painful economic reforms down the road and Italy’s long-term dependence on the ECB to guarantee its funding. As standards of living and economic performance continue to diverge within the Eurozone, its political viability comes more and more under threat.

Source: IMF WEO, Bank of Italy, Istat, Record. Debt is Projected using IMF WEO forecasts of growth and inflation, and current 10 year bond yields for interest rates.

Short-term European political stability        

The most significant short-term source of animosity between the new Italian government and the EU will be fiscal spending. Earlier demands to exclude ECB-held debt from their sustainable debt calculation have been dropped, but the direction of travel is still a cause for concern. If Italy chooses to de facto break the Eurozone’s fiscal rules, the Commission and ECB have no real source of leverage against them. In theory, an Excessive Deficit Procedure would be instigated, but in practice, this has very little teeth. Despite the threats in the Stability and Growth Pact, no fine has ever been imposed on an EU economy, most likely because the Commission knows they would have simply refused to pay. The most likely break on Italian spending plans is a threat from the EU to withdraw ECB lending without fiscal reform. This risks politicising the ECB, though. At the same time, the Italian government looks to have little leverage versus the EU. Any threat to leave the euro would be incredible given that most Italians continue to support membership (Figure 2).

Source: European Commission

Given the spending plans of the government, and the toxic political fallout, investors will likely be concerned. The key factor ensuring the long-run solvency of the Italian economy is the ECB. It is still purchasing around €4billion of Italian debt per month and would realistically increase these purchases were the solvency of the Italian government seriously in question. There is a major political risk associated with this approach, though. In the current environment, where Northern policymakers already feel that QE has outstayed its welcome, ECB intervention to ensure the solvency of a profligate peripheral economy would be toxic. In extremis, if Italian fiscal policy prevents the ECB from tightening as inflation increases in the rest of the Eurozone, it would be a particularly pernicious form of policy insolvency, with attendant grievance for the rest of the Eurozone. Thus although the ECB will likely intervene before capital flight threatens Italian membership of the euro, Italy may experience significant pain before this help is forthcoming.

Eurozone reform

The new government will be a thorn in the side of Eurozone reform efforts. While ostensibly M5S railed against banking, the demands being placed on Italian banks to set aside more capital for NPLs could be resisted by the new government if they come from the ECB or the European Commission. Assuming that Germany continues to insist on this as a prerequisite for completion of the banking union’s common deposit insurance scheme, this looks as though it could derail banking union completion altogether. As significantly, the political dynamics described above could sour European politics to the extent that any enthusiasm for reform of the Eurozone’s institutions will be lost. For European reformers, this has come at the worst possible time.

The tide appears to be turning against meaningful Eurozone reform in any case. In German finance minister Scholz’s recent budget speech he ditched any commitment to putting the European Stability Mechanism into EU law, providing a fiscal backstop to the Single Resolution Fund, and enlarging the EU budget. This confirms that the German government is backtracking on Macron’s proposed reform agenda.

The danger of these developments to the long-run viability of the Eurozone cannot be overstated. Regarding the banking union, the danger of not having a fully-funded Single Resolution Mechanism is that in a crisis, responsibility could fall again to national governments. With a banking sector balance sheet 2.3 times annual GDP and a recent history of bank bailouts (in the face of Single Supervisory Mechanism rules), this is a particular concern to Italy. With deep cross-border financial linkages, the politics of this can be very messy (as we have seen in the past). Likewise, without a common deposit insurance scheme, any banking crisis will infect the economy more viciously.

On macroeconomics, the Eurozone remains exposed to asymmetric shocks. Under the current set-up, an economy faced with a drop in domestic demand is unable to use any of the usual adjustment mechanisms. Nominal exchange rate devaluation is precluded by euro membership, monetary policy expansion is not possible without a change of ECB policy, and fiscal expansion is in theory prohibited by the Stability and Growth Pact, and de facto ruled out by the already high levels of government debt in most of the peripheral economies. The only adjustment available to the economy is a painful internal devaluation. With political relations between the South and North of Europe likely souring and the probability of significant European-level spending to balance demand across the Eurozone shrinking, the periphery of the Eurozone will be just as exposed to the next crisis as the last.


There are many ways this could result in a benign outcome. For one, Italian governments are notoriously short-lived, and with two inexperienced parties with such divergent outlooks, it is possible that this one will not survive long enough to do significant damage. The risks are significant, however. It would be a mistake to interpret these as entirely economic. So long as a central bank can bail out its government, fiscal insolvency (as opposed to policy insolvency) is not actually a major risk. There is a question of how much pain the ECB will subject Italy to before intervening, though. This introduces short-run risk for Italian fixed income, and most likely the euro. In the long run, however, the major risks are to the Eurozone itself. The nature of the Eurozone’s setup is that the political fallout from the steps the ECB would have to take to ensure financial stability could be very painful. This could stymie reform efforts. The Eurozone was woefully unprepared for the last economic crisis; the new Italian government might kill off its hopes of being in any better shape next time.

FX markets in the Trump era

  • Since the US presidential election on November 9th, markets have generally welcomed the more conciliatory tone from the President-elect Donald Trump.
  • How might the changing economic environment affect currency hedging decisions, and what does this mean for currency returns?

Since the US presidential election on November 9th, markets have welcomed the more conciliatory tone from the President-elect Donald Trump. Contrary to expectations, developed market equities have outperformed, while bond markets have sold off on the back of infrastructure-inspired growth expectations and a step up in nominal and real yields. The US dollar has been the beneficiary; since the election, the US dollar has gained against almost all developed market currencies (although, as British Prime Minister Theresa May sought to soothe businesses’ Brexit concerns, the dollar fell marginally against the pound sterling). The Japanese yen has been the worst hit as the Bank of Japan’s recent commitment to zero percent yields has amplified the impact of a US yield curve steepening.

Emerging market (EM) currencies have received no exemption from the dollar’s rally, though declines are not dissimilar to those witnessed in developed markets. Unsurprisingly, losses have been most pronounced in the Mexican peso, while other currencies also expected to suffer from protectionist policies, such as the Taiwanese dollar and Indonesian rupiah, have not fared as badly. The relatively muted reaction in other emerging market currencies is likely the result of healthy national balance sheets and co-ordinated central bank action; according to several measures, reserve adequacy had risen following the rout in 2014/15, and these reserves were utilized effectively to promote stability while the market adjusted to a new equilibrium.


spot-currency-performance-1 spot-currency-performance-2

How might this affect the decision to hedge?

The election of Donald Trump has had a profound impact on markets and may mark the beginning of a new economic era; one which emphasises fiscal policy, protectionism, and entrepreneurialism. The consequent evolution of correlations, volatility, and interest-rate differentials in the currency markets will affect the trade-offs involved with any hedging program.

We note that the US dollar has begun behaving in a more risk-on fashion of late (foreign currency and equities have moved inversely) while volatility is elevated and interest rates have repriced upwards quite significantly. The evolution of currency/equity correlations is the most uncertain factor. On one hand, the expected change of the US dollar from a low-yielding to high-yielding currency and the resultant reallocation of global risk capital could encourage pro-cyclical behaviour in USD. Additionally, economic theory[1] would suggest that a shift in policy focus away from monetary tools towards fiscal policy would increase medium-term correlation between risky assets and the US dollar. On the other hand, however, we expect US Treasuries and other USD assets to maintain their safe-haven status among investors, contributing to counter-cyclical behaviour in USD.

How do these factors affect the decision to hedge? We find that in aggregate a US dollar-based investor hedging Eurozone equities will benefit from the changing environment outlined above. Changing correlations could mean that currency hedging becomes less able to reduce portfolio volatility, but higher US interest rates would increase the excess return added by a hedging program, such that an investor’s risk-adjusted return is still boosted by currency hedging.

Using Eurozone equities as an example, in the charts below we evaluate for an optimal hedge ratio, both from the perspective of volatility and risk-adjusted return. The increase in future currency volatility implied by the option market suggests the need to hedge more, especially if the current correlation levels[2] (between Eurozone equities and EURUSD) persist at around -0.2 (left panel, light green line). However, this correlation has been on a strong downward trend since late-2014, which likely reflects changing attitudes to risk as interest rates in the US normalize. If falling equity/currency correlations intensify, portfolio volatility would be reduced by hedging less than 100%, then from a volatility perspective the optimal point at which to hedge will be lower (left panel, dark green line). However, the changing interest rate environment (sustained low rates in the Eurozone and Japan and elsewhere, with expected increases in the US) also has an effect on risk-adjusted return.

In the ‘new normal’ era of lower returns, we find that any additional returns over and above the equity risk premium have a larger impact on risk-adjusted return. For a US dollar-based investor, this means that the higher future interest rate differential (implied by interest rate swaps), earned via hedging back to the US dollar helps to offset the increased volatility at higher hedge ratios. In the second chart below we show that the risk-adjusted return increases with more hedging. Therefore, considering portfolio volatility and risk-adjusted return in combination, a 50% hedge ratio would be a sensible choice under this regime change, and could increase risk-adjusted return relative to being unhedged by up to 25%[3].



Market volatility presents opportunities in currency

The election of Trump and the higher potential of both anticipated extreme events (e.g. Brexit, other European elections) and unknown extreme events (e.g., the Swiss floor) will present interesting opportunities within currency. Positioning a currency portfolio towards various FX risk premia enables an investor to undertake specific and well understood risks, and to exploit inefficiencies within the market. Many of these risk premia extend across asset classes, including carry, momentum, value, and structural opportunities in emerging markets.

The most important takeaway from the election is that the political shake-up underway implies more extreme policy moves and a greater degree of cross-country economic dispersion. We believe this helps to expand the opportunity set within currency in a number of ways. As real interest rate distributions become wider, carry returns will tend to increase; moreover, the trends in real interest rates are a major explanatory factor in medium-term currency moves which momentum strategies can exploit. This, in turn, can lead to dislocations from fair value, which provide favourable conditions for value strategies.

In emerging market currencies, further rises in US interest rates following Trump’s election could come as a headwind to short-term performance if investors redeploy capital based on relative yield opportunities, and if EM corporates begin to re-examine hard currency borrowing decisions. That said, the medium to long-run drivers of EM currency returns – productivity growth and real interest rate differentials – are expected to remain positive relative to the US and other core developed market currencies. Short-term drawdowns therefore present more favourable entry points for investment in emerging markets, while investing against a diversified basket of short developed market currencies can insulate against country-specific shocks and enhance return.


[1] In the Mundell Fleming economic model fiscal expansion under a flexible exchange rate regime leads to currency appreciation.

[2] Correlation is measured on a 36-month basis between hedged Eurozone equity returns and long euro short US dollar currency returns.

[3] Calculated analytically based on the given assumptions and the formula for variance of a portfolio consisting of two components (A=FX; B= asset; W = 100%)

Assumed volatilities based on 1-year current and forward option implied volatility. Assumed interest rates based on 1-year current and forward swap rates. Assumed local EMU equity return based on EUR risk free rate plus 3.5% expected equity risk premium.



Record is authorised and regulated by the Financial Conduct Authority in the UK, registered as an Investment Adviser with the Securities and Exchange Commission in the US and registered as a Commodity Trading Adviser (swaps only) with the US Commodity Futures Trading Commission, is an Exempt International Adviser with the Ontario and Alberta Securities Commissions in Canada, is registered as exempt with the Australian Securities & Investment Commission.

This material has been published for professional investors & consultants. All data, unless otherwise stated in the footnote of the relevant page is as at 20 December 2016 and may have changed since. Issued in the UK by Record Currency Management Limited. This material is provided for informational purposes only and is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities, Record Currency Management Ltd products or investment services. There is no guarantee that any of the strategies and techniques will lead to superior investment performance. All beliefs based on statistical observation must be viewed in the context that past performance is no guide to the future. There is no guarantee that the manager will be able to meet return objectives and tracking error targets. Changes in rates of exchange between currencies will cause the value of investments to decrease or increase. Before making a decision to invest, you should satisfy yourself that the product is suitable for you by your own assessment or by seeking professional advice. Your individual facts and circumstances have not been taken into consideration in the production of this document.

Hedging risk warnings

Hedging foreign exchange risk is typically undertaken at periodic rebalance points so that exposures and hedges are rebalanced to reflect the new information. Interim drift between hedged positions will take place because of market movements or because of tactical asset allocation changes in the currency composition of the underlying assets. In addition, hedges are generally rebalanced around certain tolerance levels. These factors will create divergence between the hedge returns and the currency impact on the underlying assets. In addition dealing costs must be taken into account. Further divergence can be caused by proxy hedges where the proxy currency and the underlying currency move relative to one another. Finally, it is generally the case that not all currencies in the portfolio will be hedged or proxied. This is typically the case where there the cost of hedging or the lack of a proxy currency becomes a factor. The nature of hedging means that there will be intermittent cash flows which can be large monetary amounts positive and negative. Actual account set up will depend on each client’s unique requirements to manage cash flows.


The Multi-Strategy product involves passive allocation to strategies during which positions are bought and held. Exposure is maintained to the selections between the periodic rebalancing dates and is not altered due to market factors. The Multi-Strategy product is made up of an allocation to a number of the underlying strategies which may also be invested on a standalone basis.

Emerging Market Strategy

Emerging Market currencies are typically subject to greater country-specific risks than developed market currencies. As a result of this and other factors, Emerging Market currency pairs are typically more volatile than developed market currency pairs. In addition, many (although not all) Emerging Market currencies are invested in through Non-Deliverable Forwards (NDFs), which are cash settled, and the pricing of which is less deterministic than for deliverable forwards. Investment in Emerging Markets tends to be more volatile than more mature markets and the value of your investments could in some circumstances move sharply either up or down. In some circumstances currencies may become illiquid which may constrain the investment manager’s ability to realise the investment. Political risks and adverse economic circumstances are more likely to arise putting the value of your investment at risk.

Have currency markets become more choppy recently?

  • Are currency markets stuck in a period of short-term mean reversion? If so, what’s driving this and what are the implications for investors?

One straightforward way to look at the level of mean-reversion (‘side-wayness’ as opposed to ‘trendiness’) in an asset over a given period is to look at the so-called Vertical Horizontal Filter (VHF). In essence, this measure computes the difference between the highest and lowest level in the asset price and divides this by how many ‘steps’ it took on the path to get there. The VHF measure was developed in the early 1990s and a low measure would indicate a choppy market, whereas a high measure would indicate a trending phase. In terms of our own preferred definition, mathematically it is : VHF = (Max({Spot in 250 days}) – Min({Spot in 250 days})) / (SUM_{t=2}^{250} (Spot(t) – Spot(t-1))). In other words,  the numerator is the absolute value of the highest close minus the lowest close over the course of a year. The denominator is the sum of the absolute value of the difference between each day’s price and the previous day’s price over this same year.

Below we show the VHF measure for the most liquid currency relationship, namely, the EURUSD cross. The chart shows that we have been in a mean reversion period for most of this year, with effectively this pair trapped in the 1.05 to 1.15 range. Why so? We argue that the Fed backtracking over the trimming of their second rate rise this year has had an impact in dampening further prospects for US Dollar appreciation. At the same time, although the Eurozone has engaged in an expanded QE programme, inflation remains low, and so real interest rate differentials between Europe and the US are not large. The market is now, we believe, pricing in new normal or “neutral” real interest rate (1%) that is much lower than in the past (2%-3%) and this is reflected in flat forward curves in interest rates. This applies to both currency blocks. What do we need for this mean reversion to stop and a new equilibrium to be found? We believe that real rate expectations need to be dislodged from their current static equilibrium and, if so, most currency pairs, including EURUSD will find new equilibrium levels as real interest rate differentials act as drivers of spot rates going forward, something that has been driving Emerging Market currencies of late in fact.




Agreekment: Mapping out the flows

  • The initial details of the bail-out suggest that over the next three years, Greece’s hard-line creditors could be largely ‘paid-off’, leaving the door open to debt renegotiation further down the line.
  • While Greece is required to make further sacrifices in the form of asset privatisation, the deal postpones the economic and humanitarian consequences of Euro exit.
  • As always, there are significant uncertainties surrounding long run feasibility, including primary surplus and asset sale revenue assumptions.

On Monday morning Tsipras finally agreed to creditor conditions to obtain a three-year bailout worth between €86bn, which is to be funded by the European Stability Mechanism (ESM) and the International Monetary Fund (IMF). In order to get hold of the cash, Greece will be subject to a number of measures including changes to the VAT system, pension system reform, and asset transfers to the tune of €50bn to a privatisation fund. The funds from privatisation will be distributed in a 25/25/50 split to debt repayments, investment in the economy, and bank recapitalisation. With only a fairly watery Euro Summit Statement to go on, below we attempt to map out some of the big figures involved in the proposed bail-out at their face value.

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German “losses”under a full Grexit scenario: a counterfactual exercise

  • The perceived direct financial cost of a Grexit for Germany is ultimately not the real cost.
  • Both in terms of enhanced current account dynamics and via substantial cost savings for the sovereign issuer, there has been a direct benefit which we put in the order half a trillion Euros (conservative estimate) for Germany alone.

Germany financial expsoure JC Blog 2

The chart above, courtesy of Standard & Poor’s and the WSJ, purports to put the total financial losses of a full “Grexit” accruing to Germany at a grand total of EUR 90.6 billion, or just over 3.1% of German 2014 GDP.

Interestingly, this would be in addition to the transfers to Greece that all EU countries (Eurozone and non-Eurozone) make on a net basis as part of the EU budget disbursements every year. The bulk of this is falls under the rubric “cohesion and structural funds” which were set up to accelerate the “convergence” process between EU (previously EC, EEC) member states. The largest net receiver of such funds is currently Poland, followed by Greece, in absolute terms. In fact, in 2013, Greece received EUR 5.4bn or just over 2% of Greek GDP. If there is a Grexit, therefore, it would cost Germany just under EUR 100bn in this financial alone, so the numbers say…

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Circular Flow of Euros

  • Courtesy of the ECB we have allowed a costless exit route to any middle class and wealthy Greeks to park their money elsewhere in the Eurozone, free of charge, with full protection.
  • There is no formal mechanism to prevent this circular flow of Euros short of the ECB putting a maximum limit on ELA financing to the Bank of Greece and thus setting the pre-conditions for the erection of capital controls in Greece.

Or, why we will continue to pump more billions into Greece even before the next bailout/default.

So here we have it, there are now only 142 bn Euros of deposits left in the Greek banking system (end April). At the current rate this will be down to around 130 bn Euros now which is equivalent to about 10,000 Euros per Greek account holder (or 20,000 per working Greek). At some point, only the small fry is left and the amounts are small enough such that the transactions costs of leaving the Greek banking system are prohibitively high. This could be at 100bn Euro.

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