Italy feels the heat as central bankers gather at Jackson Hole

This week may feel like the last days of summer; however, it’s been incredibly useful for financial markets, and it could set the tone for trading for the rest of the year. Firstly, the preliminary PMI reports for the US, UK and Europe were released this week, we have the world’s major central bankers set to speak on Friday at the central banker’s symposium in Wyoming, and there are more troubles for Italy’s bond market.

Italy: propped up by the ECB

Italian bond yields have popped higher once again this week, with the 10-year yield rising to 3.56%. The spread between Italian and German bond yields is back at 2.25%, it is worth noting that 2.5% is considered indicative of financial stress. Thus, as the rest of the world is focussed on inflation, the Italian sovereign bond market is concerned about fiscal rules and ensuring that the ECB continues to show mercy and steps in when necessary, so that the country can fund its massive 134% debt- to – GDP ratio. News that global hedge funds now have the largest short bets on Italian sovereign bonds since the financial crisis will no doubt cause some sleepless nights in Rome and Brussels. In our view, the reason for the hedge fund pile on is down to three factors: 1, political turmoil in Rome, with the country still without a functioning government, 2, Italy’s reliance on Russian oil that threatens the economy, especially this winter, and 3, the weakness in the German economy, who is considered the lender of last resort to Italy and other fiscally unstable Eurozone nations. Hedge funds have borrowed nearly EUR40bn of Italian bonds, according to S&P Global Market Intelligence. This is not just a bet on Italian fiscal stress, but it is also hedge funds trading on the back of Russia’s threatened gas embargo, that could cause Italy’s economy to contract by 5% unless it can source other supplies.

Nationalists threaten to rip up EU fiscal rule book

On the political front, Italy faces new elections in September, with the nationalist Georgia Meloni the frontrunner at this stage. The risk is that a nationalist government would not honour Italy’s financial reform commitments that it made to the EU, and they could review Italy’s EUR 200bn economic recovery package from the EU. The market is concerned that by voting in Meloni, Italy will be biting the hand that feeds them, and could face more fiscal stress down the line.

As hedge funds try to drive up Italian bond yields, they are playing a game of chicken with the ECB, who have already announced their “anti-fragmentation tool” to ensure that countries do not suffer financial stress now that the ECB has stopped its asset purchase programme. For this trade to work, hedge fund managers need to believe that the ECB will cut Italy lose if the new government does not abide by its fiscal rules. This would be unprecedented and could lead some to worry about the break-up of the entire Eurozone. Thus, it’s a big call, and the ECB may go some way at Jackson Hole to either boost or break the hedge funds’ favourite trade.

PMI reports suggest broad employment slow down

The preliminary PMI reports were fascinating for August because they gave us some good insight into the future direction of economic growth for the major economies in the West. The reduction in output was broad-based across regions, however, the decline in the US was significantly higher than elsewhere. In the US, the decline in the composite PMI was driven by the service sector, that is different to Europe and the US, where the decline was driven by the manufacturing sector. The decline in the manufacturing sectors was particularly acute in Germany and the UK. 

There was some good news, input cost inflation slowed across regions. It rose at its slowest pace in 1.5 years in the US, in the UK, input inflation rose at its softest pace for a year. This is fuelling some hope that we could be near peak inflation. However, Europe and the UK remain at risk of further energy supply shocks that could cause spikes in inflation later this year. In the US, some businesses said that wage costs were rising, which was adding to the overall cost burden, especially in the service sector. Average prices charged also rose at slower paces than in recent months, as manufacturers and service providers tried to drive new orders, after a notable slump in demand across regions. 

Employment is also showing signs of slowing across regions. In the US, the employment component of the PMI rose at its slowest pace so far this year, in the Eurozone companies were reticent to increase employment levels and expand staffing levels. In the UK, the employment index increased at its slowest pace since March. In the US and Europe, companies have slowed hiring due to economic uncertainty, however, in the UK businesses still have concerns around attracting and retaining staff. 

After the release of these surveys, one could assume that the US economy was lagging the UK and the Eurozone. The US PMI report for August was certainly disconcerting about the health of the US economy, however, it is worth noting that economic confidence 12 months ahead was higher in the US than it was in the Eurozone and the UK. With headline inflation easing at a faster pace in the US compared to Europe and the UK, we could see the US economy pick up in the coming months, as Europe and the UK continue to deteriorate.

A word on Jackson Hole

We could all speculate about Jay Powell and what the other central bankers will say on Friday at Jackson Hole. However, the Fed in particular, are becoming more difficult to predict, and their communication strategy has shifted, so we would rather wait for the man himself to speak. However, we think that the central bankers should give the market a unified message urging governments to limit the pass-through effects of inflation, through energy price freezes etc. They should also stand firm that they will prioritise the fight against inflation, so that the economic outlook starts to brighten in 2023. If they speak with a unified message, this could boost the euro and the pound, which is anti-inflationary for these countries, and it could weaken the price of the US dollar. Fed Chair Powell is scheduled to speak at 1400 BST, this is one speech that you don’t want to miss.