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Uh-Oh...Draghi's Ammunition To Buy Italian Bonds Before The Election Is Less Than We Thought

Having successfully pulled off the announcement of the ECB’s “dovish taper” – where monthly bond purchases will be halved to Euro 30 billion from January 2018 – last month, a challenge for Mario Draghi in Q1 2018 has appeared on his radar. The ECB’s bond buying ammunition is slightly less than analysts thought and there is the small matter of the looming Italian election. The latter is likely to be held in March 2018, although it could take place as late as May. Veteran strategist, now Bloomberg columnist, Marcus Ashworth explains in "Italy's Shrinking Safety Net".

One of Mario Draghi's hands is being tied behind his back just as bond markets may need his help the most. Data released by the European Central Bank this week show the ECB president will have reduced scope to buy Italian bonds if markets start convulsing ahead of the country's general election in the spring. From January, the ECB's Quantitative Easing program will pare its monthly bond purchases by 50 percent to 30 billion euros ($35 billion). Draghi has sought to soften this so-called tapering by emphasizing how the ECB can reinvest maturing bonds to pick up the shortfall.

 

There's a hitch -- the central bank said it intends only to reinvest proceeds from maturing bonds in debt of the same country. That leaves Draghi with only limited flexibility to use his buying power to the benefit of one country over another.

Monday's release showed that proceeds from these maturing securities, which could then fund new purchases of Italian bonds is both less than expected and likely skewed until after the election. Ashworth provides us with the numbers.

Monday’s release showed that proceeds from these maturing securities which could then fund further purchases of government bonds, will only be about 8.5 billion euros, less than analyst expectations of as much as 12 billion euros. This means the pace of bond purchases under the QE program will fall by about a third from this year's rate of 60 billion euros a month. The first quarter will be noticeably lighter in monthly redemptions compared with the rest of 2018. The big months for Italian redemptions won't come until April and October.

This is inconvenient, especially as the ECB had already been “pushing the envelope” in terms of Italian purchases (and French), as Ashworth laments.

The ECB has already spent most of 2017 buying more Italian bonds than the capital key, a formula that determines how much of each nation's debt the central bank can buy, would suggest. That variation is allowable - but it leaves little extra available slack to cut Italy.

Ashworth notes that the fragmented nature of Italian politics could lead to problems for the Italian bond market in the run up to the election. While the anti-Euro 5-Star is the largest party, its reluctance to form coalitions has significantly reduced its chances of forming the next government. While that’s a positive, Ashworth’s biggest concern is the reaction of the bond market if Silvio Berlusconi returns to, “or even near”, power. As we discussed in “Berlusconi: The Greatest Comeback Since Lazarus?” here, last Sunday’s Sicilian elections were seen as an important barometer for the upcoming national election and Silvio is on the comeback trail.

Nationally, the PD (center-left) is just behind 5-Star, which has 28% support. In the center-right bloc, Forza Italia and the anti-immigrant, Northern League, have 14% each, while the far-right Brothers of Italy have 5%. As media outlets emphasised, much of the Sicilian election campaign focused on the personalities of those involved, rather than the “big issues”, like the economy, jobs and immigration. Ironically, we suspect that Mr Berlusconi will revel in such a situation if it continues in the upcoming national election campaign. Besides cementing the alliance between his Forza Italia, Brothers of Italy and the Northern League, we will be watching as Berlusconi seeks to overturn the ban on his running for public office. Berlusconi, of course, denies any wrongdoing.

Super Mario (Draghi) has enjoyed a charmed existence as President of the ECB. There would be a comic irony if his legacy was tainted by his corrupt, octogenarian countryman so late in his tenure. As Ashworth concludes.

Draghi's toolbox has been downsized. Investors can't say they weren't given fair warning. Their only consolation: his ability to pull a surprise at the very last moment.