Italy’s new government faces its first real test today: can the fragile coalition of radicals and centrists present a coherent budget that is palatable to the EU and won’t break the bank? If the results of this morning’s Italian debt auction are anything to go by, then the market is confident a crisis can be averted.
Today’s auction of Italian 10-year bonds saw decent demand. The bid-to-cover ratio rose to 1.44, the highest level since May, and the price Italy had to pay to attract investors to buy its debts fell, with yields falling to 2.9% down from 3.25% at the prior auction.
Italy’s government set to pass first test
This suggests that the market is confident of a few things:
- Italy’s budget proposals won’t anger the EU
- The Italian government won’t collapse on the back of this Budget
- The proposals will offer enough carrots to the anti-EU parties, such as tax cuts and pension pledges, that it will quash threats of a UK-style EU referendum.
This budget will not be perfect, Italy’s centrist finance minister has bowed to populist pressure, and it remains to be seen how Italy can balance tax cuts with big spending plans, thus problems could arise in future. However, from a trading perspective, if the coalition government can pass a Budget that all sides agree to then the it will have passed its first formal test, which is positive for European asset prices. This is why the euro has backed away from earlier lows versus the dollar, and why Italian bond yields remain below 3%, nowhere near danger territory.
Italian bank stocks not feeling the love
Of course, there is always the chance of a glitch at the 11th hour, and if this threatens the delivery of the Budget or a collapse of the government, then we would expect a big reaction in the euro and Italian bonds. Interestingly, The FTSE MIB Italian bank index ETF is lower on Thursday. This suggests that stock investors are not confident that this Budget is good news for Italian banks. Indeed, if the Budget does include a boost to public spending then it reduces the amount of money available for the government to bail out Italy’s troubled lenders, which ultimately makes them a riskier investment. Thus, Italian bank stocks may continue to come under pressure in the aftermath of this Budget.
Why we are concerned about US growth
Elsewhere, the dollar remains king of the FX space after last night’s FOMC meeting. There was something for both the doves and the hawks from last night’s meeting, however the fact that the FOMC’s own dot plot is predicting a move above the US’s neutral interest rate of 2.8% in 2019 is a hawkish move.
The one area that is worthy of mention is the GDP projection. The Fed increased its expectations for GDP in 2018 to 3.1%, however with GDP running at 4.1% in Q2, this suggests that the Fed is looking for a moderation in GDP into the end of the year.
Right now, this is not impacting the dollar, most likely because a slowdown in growth won’t be enough to stop the Fed from hiking interest rates, however, ultimately the Fed’s actual policy path will be dependent on the economic data, and if the slowdown is too sharp then 3 rate hikes in 2019 could be too optimistic.
President Trump: the biggest risk to the US stock market rally
There are two things that could threaten US growth. Firstly, world trade. The WTO lowered its expectations for trade growth this year to 3.9% from 4.4% earlier this year, this slowdown is expected to last into next year, with trade expansion falling to 3.7% in 2019 down from the WTO’s previous estimate of 4%. The WTO said that the downgrade came from global trade wars and called on the major global economies to “work through their differences and show restraint”. There’s not much chance of that happening if President Trump’s press conference on Wednesday is anything to go by.
As we head into the final quarter of the year, Trump and his trade policies could be the biggest risk to the US stock market. After the WTO downgrade, the Dow Jones futures market is predicting a lower open on Thursday to the tune of 15 points. Secondly, trade tariffs are inflationary. We have already seen the inflation expectations component of the Markit September PMI survey rise sharply. This could keep pressure on the Fed to hike interest rates, something President Trump isn’t fond of, at the same time as growth is slowing, which is bad news for stocks.
A higher dollar, higher interest rates and the prospect of weaker growth, doesn’t seem like the environment for US stocks to rally today. Thus, we would not be surprised to see declines in the US indices in the coming hours.
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