The Bond market with ultimately take Italy down...

Taking back control... Last week my son had his last lesson in his school which he had been at since he started Elementare. It was a sad moment for him and the friends he had made and a relief for us as we had become more and more concerned about the running of the school and the interaction between teacher and class. So we took the decision into our hands and moved him to another school which to be fair, could be the same, better or worse, but we felt that we had to do something.  He started on Monday morning and at the time of writing this I await to see how the day went.  Our fingers are crossed. You may ask why I am telling you this story because it has nothing to do with the bond market taking Italy down.  However, in many respects it has similarities about 'taking back control' (I hate to paraphrase the Brexit Leave campaign, but it works in this instance). The International bond market will ultimately dictate and control what happens in Italy regarding its fight to lift its budgetary spending.    So what is the Bond market?   A Bond is a loan to a Government, corporate or individual, which is guaranteed a set rate of interest at the start of the loan and has a set maturity date. i.e. I buy an Italian Government Bond with €10,000 of my money. I am, in effect, lending this to the Italian government.  They promise to pay me a rate of interest for the duration of the Bond (the duration is the period which I leave my money with the government, i.e. 1/2/3/5/10/20 years etc) and pay me the initial investment back at the maturity date. In normal circumstances the longer the duration the higher the interest rate. The relationship between the price of the Bond (how much it can be bought and sold for) and the interest rate it offers me is exactly like a seesaw in a child’s playground. When the price I can buy a Bond for rises then the interest rate goes down. When the interest rate goes up, the price I can sell it for goes down.  The Bond market is a mechanism by which these Bonds can be bought and sold. That sounds simple enough! On the surface Bond markets might look pretty uninteresting. Yet, below the surface, bond markets have the power to change government policy, and even change governments, as we may well see in Italy.  So why then does the Bond market seemingly have so much control of world politics? (When I refer to the Bond market in this blog, I am referring to the Government bond market. There are other types of Bonds as listed above, but they are not the subject of this blog.) Why is the Bond Market Important? Governments need to borrow money. They borrow money through selling bonds to investors who want to lend them money. These can be individuals, but more often than not it is large investment houses and, more generally, the private sector.  In other words, if I offer to lend you money, I want to know that I am getting a set rate of return throughout the life of that loan and that you are not going to default on that loan and not pay me my initial investment back. Usually, investors are quite happy to buy government bonds. They are generally seen as a safe investment (governments don't 'USUALLY' default). Fear of Default   Italy’s public debt stands at more than 130% of GDP, only Greece has more debt within the eurozone.  Yet Italy’s debt is even worse because the Italian central bank also owes the European Central Bank €400bn. What this shows is that money within the eurozone is fleeing from Italy to go to safer places. In reality, it’s a form of debt that only matters if Italy leaves the euro because Italy would have to pay it back at that point.  In short, Italy is extraordinarily indebted. I don't need anyone to tell me this as I live in Rome and the indebtedness is evident in every step of life: underinvestment in schools, roads, infrastructure, hospitals, rubbish collection, public transport....do I need to go on?  What can a country do to rid itself of debt?  Typically, a country can get rid of its debt by outgrowing it (paying it back honestly); inflating it away (paying it back dishonestly); or defaulting on it (not paying it back in full or at all).   The problem is that Italy does not have control on inflating its debt away (as it historically has done) and is therefore trying to get rid of the debt by outgrowing it…honestly!!  It has increased its planned deficit (to 2.4%) in order to grow, (stimulate economic growth), its way out of the debt. But this could be a tough ask. Italy’s economy appears to have given up growing since it joined the euro. The economy has not grown at all.  A country with its own central bank can always drive for inflation. Italy, as part of the eurozone does not have that option as money creation is dictated by the European Central bank (ECB). The ECB bank has under the auspices of Mario Draghi, the world’s most talented central banker, opted to try and inflate the eurozone debt away. Given that the eurozone is a melting pot of different countries with varying levels of growth, efficiency and debt, inflation could come too late for Italy, if at all.  Will Italy default on its debt?  When there is more fear around the political management of a country, i.e. 5Stelle and Salvini, then there is a corresponding rise in the fear of default. In Italy's case the fear is an outright debt default.  The probability of a debt default raises the risk and when the risk is high it dissuades investors to buy. To attract new investors to buy their bonds the Italian state, in this case, must offer a higher interest rate to compensate you for the additional risk you are now taking. This is exactly what has happened to Italy over fears that 5Stelle and La Lega are mismanaging the country’s financial resources.  It is pure supply and demand at heart: if you want me to buy your risky Bond, then I have to be sufficiently rewarded for doing so. If I can't attract buyers at the same interest rate, then I have to raise it in order to attract investors.  The greater the chance of default, the higher the interest rate that the Italian state will have to offer to attract buyers. Very simply the bond market is the largest purchaser of Italian debt. If they assume that the risk is too high then buyers will demand a higher interest rate. This means that more money has to be put aside by the state to cover interest payments instead of providing money for schools, hospitals etc. It is understandable why it is such a sensitive topic. The point is that the bond market has the capacity to throw the governments best laid spending plans into confusion. Whilst Salvini wants to see a flat tax and Di Maio would like to introduce the reddito cittadinanza, for the poorest in society, if more money has to be allocated to repaying the already burdensome Italian debt then some programmes may have to be cut or suspended altogether. This would go against their manifesto pledges and potentially create a leadership contest and/or another general election. Despite all this, is it the case that the Italian government will default on its debt? The answer is very likely that it won't. To explain this I quote Mohamed A El_Erian a Bloomberg Columnist: Italy doesn't have a current account deficit (it has a surplus) and the average duration of its outstanding debt is longer. With lower risk of financial default in the short-term, the main determinant of possible disruption resides in dislocations originating from domestic and regional politics.  That is the factor for investors to monitor closely.  So where does this leave the Italian state? It is important to keep an eye on the sentiment of the bond market and the interest rate on Italian government debt.  The bond market has the ability to overthrow governments. We saw this in the summer of 2012 when the bond markets lost confidence in Silvio Berlusconi and the interest rate on Italian short-term government debt rose to 6%pa. That same summer he stepped down and the EU technocrat Mario Monti took his place.  The bottom line is that whilst most investors worry about the stock market (since their money is mostly invested in corporate stocks), the various Governments around the world have to keep a sharp eye on the bond markets. There is no fixed level of debt when bond markets will turn on a country. It doesn't just depend on levels of debt, but issues such as political stability, expectations of future growth etc.  Ultimately, the Bond markets are a more powerful machine than the stock markets and exceed the world's stock market in size by nearly 2 to 1. You can be sure that more fun will ensue in the coming weeks months and years as the bond markets move in and out of favour with Italy.