What does the credibility of the Italian government have to do with the fortunes of Mexico’s peso? Those are two things most people would never connect yet they aren’t just drawn together by a common thread, that same thread also ties together pretty much everything in between. It may seem like a convoluted chain linking Rome to Mexico City then to you and me, though it’s not as big a stretch as you would first think.
In early March 2018, the Italians held elections which produced no outright winner. It was still the initial era of populism, the undercurrent of dissatisfaction which had been boiling and raging underneath ever since 2008 finally breaking above the surface. Donald Trump and Brexit had only been a little over a year before, now it was time for Big Time Continental Europe to express its own displeasure, too.
There were plenty of reasons for this shifting tide, yet they all trace back to a single statistic; rather, what that stat really represents. According to Eurostat, the European agency which tracks these things, Italian GDP had reached its peak along with pretty much the rest of Europe and the developed world in the first quarter of 2008 at €426.6 billion (seasonally adjusted quarterly rate).
Over the fifteen and a half years since then, GDP has yet to recover that level. While that should be more than enough to describe the dire situation, it actually leaves something to be desired since the absolute comparison understates the true gravity.
We don’t live in a static world meaning output like anything else should always be constantly growing. The rate of expansion is typically a very big topic since a few percentage points here or there can lead to enormous consequences. A difference between lesser growth rates and just flat-out lower output is incomprehensible (and all the ECB wishes to talk about is a booming economy, too).
Even if you didn’t and don't know the numbers, you definitely feel the difference.
By March 2018, not only had it been a decade since peak Italian economy, there had been at least one other official declared recession in between which set Italy back even further. Even worse, that second recession was blamed, in large part, on the Italian government’s inability to control its spending.
What was called the European sovereign debt crisis was far more than taking a closer look at the finances of the Club Med group. It was a collateral shortage and a big one. Having learned something important that authorities worldwide have yet to grasp, monetary participants had come to understand the nature of collateral risks because they didn’t have another choice.
If I was forced to describe the 2008 crisis in a single term, it would definitely be collateral shortage. Having suffered through that all the way to the end in March 2009, it was mere months later when the first stirring of Greek bonds began to upset the entire system all over again and in exactly the same way as 2007’s “subprime mortgage” debacle.
Greece was, in fact, the next subprime.
The problem wasn’t specifically government deficits as it was lack of dependable market for some bonds given a higher level of uncertainty surrounding the instruments. Collateral was supposed to mitigate risk. Yet starting in 2007, it had become the source of more than risk and from securities which were previously thought, and priced, as the highest quality therefore safest.
Bear Stearns was taken down because it ran out of negotiable collateral. Same for Lehman and AIG. Lessons were learned among those who can’t escape the practice.
Italy’s debts start out trading in a similar market, but the way in which they are treated by that market at various moments in monetary history ends up being destructively different.
Given the statistics cited above, you can see where this was all going. After being told to bear much of the brunt of Europe’s fiscal adjustment in order to get out of 2011-12, told by Italian Mario Draghi head of the ECB, where was the recovery? Several LTROs from Mario, a T-LTRO then full-blown QE later, by March 2018 none was to be found.
The largest bloc of votes in early 2018 went to the upstarts, the Five Star Movement party, the populists. Without a clear majority or the ability to piece together a stable coalition, M5S, as it is known, tried several times to mold a coalition government. It didn’t go smoothly, to put it kindly.
By May 2018, the unstable political situation spilled over into Italian bond considerations. The Italians had already suffered one additional indignity first – the very instruments Draghi said needed to be reformed actually became the backbone of European collateral from the middle 2010s onward if only by default.
Without a legit recovery, fiscal reforms were all cosmetic. The government’s financial situation had hardly changed. So much of “austerity” depends on, once again, the economic growth to provide sufficient space to get it all done. Italy did the austerity without any reward for its trouble. The bond market cares more about the latter than the former.
On April 26, 2018, the spread between the yield for the Italian 10-year BTP and its German 10-year bund counterpart was a non-threatening, minimal 111.7 bps. With turmoil gripping Rome given more than a month had passed without any resolution from the election, in a matter of a month that same spread doubled.
And it broke the world.
OK, that’s too strong a statement, though it isn’t as far off as you’d want to believe. It all came to a head on May 29, 2018. The Italy-Germany spread was a painful 222.9 bps on the 28th, then it absolutely exploded to 286.0 bps on the 29th setting off a gigantic chain reaction which would reverberate throughout the worldwide monetary system, all of its financial components before also engulfing the real economy all until the coronavirus showed up.
They blamed trade wars, too.
To this day, May 29 sticks out on practically every chart beginning with other top-quality forms of collateral, not just euro-denominated equivalents like bunds also US Treasuries! We see May 29 in TIPS or US$ swap spreads. Anything remotely related to collateral, and there’s not much that isn’t, bears the scar.
That’s because a serious scramble for collateral in one part of the eurodollar world creates knock-on effects in the others. And when the one part is Italy, regrettably a big piece, there’s no getting around it.
We were reminded of this unfixed fault just last year when the world encountered a similar threat though that time it wasn’t because of election politics. Rather, Italian bond spreads blew out to 2018 proportions on fears energy prices were going to tank the economy, spike Rome’s deficit, and bleed the Italian portion of the European bond market dry.
By September 2022, the same Italy-Germany spread was back over 200 bps producing grave effects felt first and foremost in London, yes, the UK, though hardly limited to the “gilt” blowup. It was a massive worldwide collateral squeeze.
One year later, the monetary world is (being) set up for a repeat, only now one that combined 2018 with 2022. Once more Italy, this time a mixture of fiscal uncertainty, almost certain its deepening economic recession, and just in time to amplify all those resurgent oil prices.
The Italian economy is already back in contraction since around the third quarter of last year (right around when the collateral blowup occurred), even if a mild drop to this point. But, again, Italy like the rest of the world never recovered – GDP peaked in the first quarter of this year at a quarterly rate of €419.9 billion and you’ve no doubt noticed how that’s still substantially less than Q1 2008.
The result is a toxic mix best described by Italy-German spreads in October 2023 back over 200 bps and firmly in the danger zone. As they’ve been moving back in that direction, other collateral indications have felt and displayed the reverberations.
It started in late July, thereabouts, as both Italy spreads and others began to reverse their prior trends (improving modestly following the earlier banking difficulties), everything from interest rate swaps spreads (US$) connected to collateral conditions to Japanese government bill yields (as collateral alternatives). The dollar started to surge against the world’s other currencies, in particular India’s rupee and even Mexico’s peso.
That last one may, in fact, be the most compelling indicator of the bunch. Not to downplay those others which have proven critical time and again, and not just 2018 or 2022, but the Mexican peso had been on an incredible run for nearly a year and a half. Bucking every other currency, the peso rose throughout 2022, even surging in the last half of the year while at the very same time all the rest were plunging due in huge part to the energy-driven fears over Italian bonds.
The reason for Mexico’s fortune is simple: nearshoring. Money had been pouring in to the country from all over seeking to take advantage of reworked supply chains – using NAFTA to do it. Funds come in, using eurodollar medium, the peso goes up.
Since late July, though, the peso has gone down all of a sudden. Something has seriously changed in the eurodollar world that even Mexico’s currency can no longer escape it.
The problem isn’t really Rome or even governments, it’s the insufficiency and inattention to collateral issues that remain, to this day, a global weak spot. This latest scramble which has been unleashed is particularly dastardly, too, because it combines all the elements to make for the big retreat: politics, oil, banks, and more and deeper recession.
I don’t know how many in Mexico might speak Italian, but the Mexican currency is being forced into speaking the language of Italian bonds right now. The one that had emerged unscathed from 2022 can’t escape July 2023.
