Italy Election Preview: Here Are The Main Questions On Investors' Minds

Until Trump's Thursday trade war announcement, and last night's shock statement by Kuroda previewing the end of the BOJ's QE, the single biggest event risk was the Italian election this Sunday, March 4 (together with the SPD "grand coalition" referendum held concurrently in Germany whose outcome could seal Merkel's fate).

And yet, ahead of the election, investors are feeling especially complacent, with no notable moves in terms of Italy-specific risk assets because, as Reuters noted, "the economy is strengthening and anti-euro sentiment is waning in the single-currency bloc" although many beg to differ. Still, the vote has the potential to throw them a curve ball.

Below we comment on some of the key questions surrounding of the election.

First, the basics: 

The Italian election takes place Sunday, March 4. Polls will be open from 06:00 GMT to 22:00 GMT. As results filter through from 22:00 GMT / 17:00 EST Sunday, the most contentious seats are considered in the south. 

The election will elect the 945 members of the parliament for the 18th legislature – specifically, to select the 630 members of the Camera dei Deputati (lower chamber) and 315 of the Camera del Senato (the Senate/upper house). Note that the electorate does not vote for the PM. 

The main parties in contention are: 

Forza Italia (center-right) led by former PM Silvio Berlusconi 

Democratic Party (center-left, PD) led by former PM Matteo Renzi 

5 Star Movement (anti-establishment, M5S) led by Luigi Di Maio – seen as the most market negative outcome. 

What are the expectations? 

Reuters has put together a useful poll tracker which can be found at the following website. 

No single party or coalition is expected to reach a parliamentary majority thanks to the new electoral law (see below). For example, Bloomberg surveyed 15 economists on February 2-7, with 38% expecting a hung parliament, and 33% a grand coalition: 

What is the most likely outcome? 

Latest polls point to a hung parliament, where no one party or coalition has a majority to form a government. If this happens, Italian President Sergio Mattarella, will call on parties to form a broader coalition of pre-election adversaries. This could include the ruling centre-left Democratic Party and Silvio Berlusconi's Forza Italia. 

Analysts see a hung parliament, leading to a broad coalition that includes mainstream parties, as the most positive market outcome because it could result in political stability and policy continuity on Europe. Even in this situation, any uncertainty over the government's make-up could lead to short-term volatility. 

While unlikely, the most feasible coalition would be center-right (CR), given that M5S has ruled out a coalition. A CR coalition would be formed by Forza Italia, Lega Nord (the anti-south, anti-immigrant Northern League), Fratelli d'Italia (Brothers of Italy) and Noi con l'Italia (Us with Italy). 

All the polls show the Five Star Movement (M5S) as becoming the single largest party, winning between 27% and 29% of the vote. However risks for EUR have diminished since the party dropped its call for a referendum on the euro in mid-January. A (market positive) surprise would be an outright center-right victory. 

Will the winner tackle Italy's giant debt pile? 

Reuters here is laconic: "Probably not." 

Whatever Italy's next government looks like, the chances that it will push through long-term term structural reforms to improve Italy's economic performance or to tackle the country's debt pile, are low. At 132% of GDP, Italy has the European Union's worst debt ratio after Greece. 

In fact election pledges could worsen the situation - Bank of Italy Governor Ignazio Visco has cautioned that parties' pledges to slash taxes and hike spending could prove counterproductive since the problem of high debt "cannot be sidestepped." That could increasingly bring investors to view Italy as the euro zone's weak link, making Italian assets vulnerable at times of market uncertainty or during the withdrawal of European Central Bank stimulus. 

What could surprise markets? 

As a reminder, this is the first election to take place under a new, untested voting system introduced last year, which makes the outcome particularly uncertain. It is possible that a coalition of centre-right parties, leading in the polls, will win a majority of its own. 

One surprise would be a centre-right victory, with the eurosceptic League as the biggest party, possibly enabling its leader to become prime minister. Success for the League, which calls the euro a "failed currency," could revive euro break-up fears and widen the gap between Italian and German bond yields. 

An election outcome that allows the League or the anti-establishment 5-Star Movement to have a central role in government may have the same effect. And if a government is not formed, fresh elections cannot be ruled out 

Surprise No. 1: The new electoral law 

One reason why there is elevated uncertainty around Sunday's election is the newly-approved electoral law called Rosatellum Bis. The new system makes seat projections very difficult and throws historical lessons out of the window. 

2/3 of seats are elected under a proportional voting system and the remaining 1/3 elected in a 'first-past-the-post' electoral system – this favors the most prominent people in the parties seats in Parliament, and thus has been criticized by the M5S. 

Each party needs to get at least 3% of votes in both chambers to get into parliament, while coalitions need 10%. 

Surprise No. 2: Uncertainty! 

The high number of undecided voters means that polls and projections have to be taken with a pinch of salt. Politico cites recent polls as saying as much as 30-45%of the electorate is undecided. 

"Around 10mn Italians haven't decided yet if they will vote and for whom," Antonio Noto, head of the IPR polling agency said. "That means that the result may change in a substantial way in the last few days before the vote." 

Some political commentators have also suggested that tactical voting may be at play – given the PD are expected to be defeated, we may see center-left voting to block M5S. 

What about Germany's SPD ballot results? 

A "thumbs-up" for Germany's coalition deal will suggest modest fiscal expansion, adding in turn to better growth and higher inflation. That could hasten the end of the cheap-money era and keep upward pressure on borrowing costs. If Italy's election too passes without major ructions, it will remove a layer of political risk from the calendar and reinforce the case for unwinding ECB stimulus. 

Focus can then turn to the next ECB chief, a post that changes hands next year. While speculation is of a German - possibly the hawkish Bundesbank chief Jens Weidmann - taking the reins after the departure of "southerner" Mario Draghi - Germany's Social Democrats say they have not discussed backing Weidmann for the role. 

But any negative surprise outcome from Italy or Germany could encourage the ECB to keep asset purchases in place beyond their September end-date, in turn prompting investors to rethink the timing of rate rises. 

Does EUR care? 

Last Friday a Citi spot EUR trader noted: "I still find the whole Italian election fascinating. No one is talking about it (they shouldn't), but inside everyone is holding back a little bit (they shouldn't)." 

To the point, Citi's options desk noted "something remarkable" about the Italian election: the main characteristic of this event is the lack of significant flows in the short dates. Event variance is stable and this chart below from Bloomberg is a case in point. 

Bottom line: unlike the much more "exciting" French election last year, the Italian election is not a simple one-off event risk for EUR – "it is not a binary event where one result is market positive, the other negative" as Citi puts it. The most likely outcome is that the prolonged period of coalition talks after the election will play out much like the German elections; as a reminder, after the hung parliament in the 2013 election, it took 62 days to elect a government.

In other words, Sunday's event, absent a major surprise, will mean auto-pilot continuity for Italy, and Europe.

The Market's Junk Problem

The market has a big junk problem and it's very evident when taking a close look at the chart of $JNK, the high yield bond ETF. It's been a brilliant technical indicator as of late and was one of the signals employed in fading the rally earlier in the week.

Note that $JNK has been on a steady uptrend for the better part of a year when suddenly it made a lower high in January while $SPX kept ignoring it and went on to make new highs. Not listening to $JNK was a mistake on the side of market participants.  $JNK signaled troubles was brewing and once markets finally caught on it was all over.

In process of the correction $JNK broke a key supporting trend line and this proved to be a key signal this week:

Note the 2 attempts to recapture the trend line these past 2 weeks. Both attempts failed precisely at the trend line and each time produced selling in markets including this week.

What does this tell us: Firstly, technicals have worked nicely on this chart. The trend line break is bearish and the failure to recapture the trend line is bearish. Doesn't mean $JNK won't try again, and it if does it'll be bullish for markets, but without a recapture it's not good news for markets and this trend line is moving away, so bull need a solid rally to emerge to race up there.

As long as $JNK stays above the 35.70 gap odds for a big rally are improving. Fall below the gap and markets may make new lows or retests lows.

But as long as $JNK remains below the broken trend line markets are having a junk problem.

Fabrizio 

Another "Inconvenient Truth": Market Tops Are Violent Inflection Points After All

Over the course of the last few days, bulls' enthusiasm has hit the proverbial brick wall, as stocks have reeled lower in an apparent rerun of the near record plunge observed at the beginning of February. But fear not: following up on Goldman's prediction from last week that stock buybacks are set to soar over 20% this year, rising to a record $650BN 2018, this morning JPMorgan decided to double down, and forecast an even more ridiculous amount of 2018 buybacks: a whopping $842BN, or just over $70BN per month.

It goes without saying that such massive amoounts a price indiscriminate, debt-funded purchases of stocks would do miracles for prices, which then brings us to the good news.

As Nomura's Charlie McElligott writes, we are currently back in the "low buyback seasonality" period, as the ammo spent coming out of the earnings blackout (when the market was tanking and corporates were gobbling shares) typically again slows ahead of more buying coming back online in the month-ish period prior to Q1 earnings. So in that case, expect buybacks to again pick-up in another week or two into the blackout kick-off mid-April.  

This as always will help "stop the bleed" and reverse the macro-driven market from a flow-perspective, which then calms into the constructive "micro" of "earnings calm."

In other words, while retail investors may be running on fumes, and institutions continue to be better sellers than buyers, it will be corporate repurchases that save the market once again, as the following chart from UBS shows. 

Now the bad news.

As McElligott also points out, discussing "a super interesting analog" run by his Nomura colleague Anthony Antonucci regarding a theoretical ability to pinpoint prior market tops, "essentially what the below is "proving-out" is that contrary to the recently-heard narrative that markets fade and churn at highs before grinding lower, with folks saying there is "no real violence" at the inflection-point—Anthony's data shows something very different."

What the table above shows is the following:

The 1-week move on average on a lookback is -2.3% (versus this current selloff at -3.9% through the same period); the 2-week-out move sees a recovery nearing back towards 'flat' -0.7% on avg (with this selloff trading back to the exact same -0.7%); then the 1-month move gets very sloppy at -5.2% on avg (with this selloff's 1m selldown at -3.2%); and finally the 3-month really gets murky -9.6% on average (as we currently at just 5-weeks out sit -6.8%).  Some stuff that is "rhyming" here…

In other words, market tops are indeed violent, and as a reminder, we just had the most violent month in many years. Naturally, it will be up to the price action over the next few weeks to determine if we continue with the downward slope, validating the "market top" formation, or whether the abovementioned buyback frenzy will once again save stocks from an ugly encounter with gravity.

Beware, There Is No Liquidity In This Market, Morgan Stanley Warns

As the recent swoon in the S&P showed, the lasting pain from the February vol unwind has combined with multiple policy shocks to weigh on markets. We showed the concurrent impact of the various catalysts leading to the current risk off environment with the following DB chart:

However, while the early Feb swoon was largely the result of the "Quant Quake", the transmission mechanism in this move lower is no longer systematic funds / vol target strategies, according to Morgan Stanley's Chris Metli. Instead, the MS executive director notes that this time selling has come from more fundamental/discretionary investors – the MS PB Content team has noted that there were multiple large sell days from L/S HFs this week (versus buying the week of Feb 5th ) – exacerbated by a lack of liquidity.

Here the lack of liquidity is important. 

As the MS Futures team has been pointing out since the start of the year, available size at the top of the book in the US equity futures market - i.e. how many futures can trade without impacting price - has deteriorated sharply and has remained depressed since Feb 5th. In fact as shown in the chart below, using that metric, market liquidity is now the worst since the financial crisis. There are similar signs of reduced size / wider spreads in cash and options markets as well.

As MS notes, part of the decline in liquidity is a natural function of higher volatility – spreads usually widen and available size drops when volatility increases. But the recent decline in liquidity is sharper than typically happens when volatility spikes – based on data since 2011, available size in ES futures is 3 standard deviations too low right now versus where VIX says it should be.

There are several potential drivers of the liquidity deterioration. The first is that market makers took substantial losses on the vol shock. In the options market, dealers likely had to buy over $100mm of vega to cover short vol positions that were moving against them. When market makers take losses, the natural step is to pull back and provide less liquidity.

The second cause for plunging liquidity is that there is less vol supply now, which means volatility moves higher faster as spot declines, which then feeds back into liquidity, etc. The increase in volatility and unwind of short vol exposures in early February meant that volatility sellers took losses, and as a result have pulled back on supplying volatility to the market.

The third reason is more structural – as markets have become more fragmented and more volume has shifted to closing auctions, there is less natural liquidity during the trading day.

The final potential culprit are tighter financial conditions/higher cost of capital, especially in the form of surging FRA-OIS which we have documented in recent days. Whether this is actually impacting the ability of market makers to provide liquidity is unclear – but tighter financing certainly increases the fragility of the market. The bear case, MS notes, is that this is a function of a more hawkish Fed combined with the end of QE (which most market participants have stopped talking about).

Yet while liquidity is abysmal, there risk of violent moves as a result of systematic fund deleveraging is also lower. That said, there is some risk remaining from the systematic / vol community though according to MS: 

Of all of the systematic funds, risk parity funds likely remain the most levered, and could bring supply – but the key risk for them is higher stock-bond correlation, which QDS does not think is likely just yet (see Don't Fear a Little Inflation, Yet from Feb 26th 2018) 

Institutional short volatility strategies have largely remained invested throughout the last month – should volatility remain higher for longer (as QDS thinks it will) there could be covering here 

So what happens next? As Morgan Stanley summarizes, to some extent this selloff is following the usual playbook – when market participants feel enough pain from the initial shock, markets retest the lows and volatility stays higher for longer. The path forward in spot will be driven by: 

How fundamental investors weather this storm – no signs of panic yet, but as they give up more and more performance their resilience will be tested 

Financial conditions and whether market makers can get some relief 

The bank's conclusion: "given the instabilities and lack of liquidity in the market, investors should be wary to catch a falling knife and wait for some stability before aggressively buying. With VIX already in the high 20s, QDS continues to think longer-dated and forward volatility is a better buy."

Never Mind Volatility: Systemic Risk Is Rising

So who's holding the hot potato of systemic risk now? Everyone.

One of the greatest con jobs of the past 9 years is the status quo's equivalence of risk and volatility: risk = volatility: so if volatility is low, then risk is low. Wrong: volatility once reflected specific short-term aspects of risk, but measures of volatility such as the VIX have been hijacked to generate the illusion that risk is low.

But even an unmanipulated VIX doesn't reflect the true measure of systemic risk.

The financial industry has reaped enormous "guaranteed" gains by betting against volatility. As volatility steadily declined over the past two years, billions of dollars were reaped by constantly betting that volatility would continue declining.

Other "guaranteed" trades have been corporate buybacks funded by cheap credit and passive index funds Central bank policies--near-zero interest rates and "we've got your back" asset purchases that made buying every dip a no-brainer trading strategy--have changed as banks attempt to dial back their stimulus and near-zero rates, and as a result volatility cannot continue declining in a nice straight line heading toward zero.

Higher interest rates have introduced a measure of uncertainty in another "guaranteed gains" trade--betting that interest rates would continue declining. All of these trades were "guaranteed" by central bank stimulus and intervention. In effect, price discovery has been reduced to betting that central banks will continue their current policies--'don't fight the Fed."

Now that central banks have to change course, certainty has morphed into uncertainty, and risk is rising, regardless of what the VIX index does on a daily basis.

Here is what a "guaranteed gains by buying the dip" market looks like: just bet that central banks will buy every dip and suppress volatility, and you're a genius.

Until the recent spot of bother that destroyed the short-volatility trade, betting on declining volatility "guaranteed gains":

Meanwhile, back in the real-world economy, wage earners' share of the economy continues stair-stepping down as every risk-asset bubble eventually pops:

Back in the good old days, corporate profits were the foundation of rising stock valuations. But corporate profits have stagnated while stocks have soared.

I discuss the inconvenient reality that risk cannot be destroyed, it can only be transferred to others. So who's holding the hot potato of systemic risk now? the short answer: every participant holding risk assets, which now includes virtually every asset class.

Suppressing volatility does not mean risk has vanished; rather, it means that risk is increasing as accurate information on systemic risk is being suppressed. The global financial system is becoming increasingly fragile and thus more prone to collapse, and an artificially low measure of volatility doesn't change this reality.

Kuroda Shocks Markets Hinting At QE End; Nikkei, USDJPY Tumble

In addition to the suddenly escalating global trade war, overnight traders had one more thing to worry about: another central bank unwinding its QE program. This happened shortly after midnight ET, when BOJ Governor Kuroda unexpectedly announced that the Bank of Japan will start thinking about how to exit its massive monetary stimulus program around the fiscal year starting in April 2019, and that there could be policy change before the 2% inflation target is achieved, marking the first time he's provided any clear guidance on timing for normalizing policy.

"Right now, the members of the policy board and I think that prices will move to reach 2 percent in around fiscal 2019. So it's logical that we would be thinking about and debating exit at that time too," he said. "I'm not saying that the negative rate of 0.1 percent and the around 0 percent aim for 10-year bond yields will never change, but it is possible. We will be discussing that at each policy meeting."

In immediate reaction, Japanese shares fell sharply, the Nikkei sliding as much as 2.9% as the Yen surged as much as 0.5%, with the USDJPY tumbling below 106, a 15 month low, while JGB yields jumped across the curve.

"Kuroda's comments are important because he officially acknowledged a change in policy was likely before the end of fiscal year 2019," said Rodrigo Catril, a currency strategist at National Australia Bank Ltd. in Sydney. "A move sub-105 yen over the coming days wouldn't be surprising under the current risk off/trade war concern environment"

In testimony that lasted about three hours, Kuroda seemed to try mitigating the negative market impact by saying that this doesn't affect his "overshooting commitment," which pledges the BOJ to continue expanding the monetary base until inflation exceeds 2 percent in a stable manner. Even with the recent easing in the pace of bond purchases by the central bank, the monetary base is still increasing at an annual pace of more than 9 percent.

By then. however, the damage had been done.

"The BOJ's stance is that in around fiscal 2019 inflation will reach 2 percent," said Yoshiki Shinke, chief economist at Dai-ichi Life Research Institute. "If inflation rises above 2 percent, to be honest it's just logical to consider an exit strategy around then."

Of course, the problem is that nobody really had, which is surprising because with the Fed already raising rates and the ECB debating normalization, Kuroda has so far snuck between the cracks, even if he has been under increasing pressure to provide details on when the BOJ may follow suit.

And while the outlook for prices and the economy have pointed for quite some time of the need to mull an eventual exit, Kuroda's acknowledgment of this is significant.

To be sure, the market did not like it.

At least Kuroda has the economy in his side: as Bloomberg reported earlier, Friday showed movement in prices and the job market that should help the central bank. Japan's unemployment rate fell to 2.4 percent, the lowest since 1993, while inflation in Tokyo rose more than expected in February, suggesting prices could move higher nationwide.

The only problem is that 30 years into its grand monetary experiment, Japan's wages have still to rise (see "Over half of Japan firms do not plan base pay rise this year") , which is a problem. Kuroda said stable 2% inflation isn't possible without wage growth of more than 3%. Pay gains are still well below this level even as the labor market continues to tighten, and Japan's unemployment rate just tumbled to a fresh 25 year low, an increasingly meaningless metric in the world's oldest society where the bulk of the population is outside the labor force.

And suggesting that perhaps Kuroda has misspoken, he added that the increases in consumer prices are still quite far from the target, and went on later to say he felt cautious or negative about changing the 0 percent target for bond yields now.

Still, if nothing else, Kuroda did provide a window of action, and as ING Bank's Rob Carnell said, when the European Central Bank begins to formally normalize its own monetary policy, it may provide a window for the BOJ to act as well.

"You don't want to be the odd-man out in this game," said Carnell.

Finally, in response to this surprising announcement, here is how some other analysts reacted to Kuroda's unexpected announcement, via Bloomberg:

National Australia Bank Ltd. (Rodrigo Catril, currency strategist) 

"Kuroda's comments are important because he officially acknowledged a change in policy was likely before the end of FY2019. Technically, however this shouldn't come as a surprise as core inflation is expected to reach 2.3% by then" 

"Still, markets shoot first and ask questions later, so yen appreciation remains the path of least resistance near term" 

"Technically dollar-yen has a lot of room to move lower and the current risk-off environment supports a stronger yen. A move sub 105 yen over the coming days wouldn't be surprising under the current risk off/trade war concern environment" 

Mitsubishi UFJ Morgan Stanley Securities (Daisaku Ueno, chief currency strategist) 

BOJ Governor Kuroda's comments will add further downward pressure on USD/JPY, which could lead it to push toward 105 in the near term 

Sentiment toward USD/JPY has already been weighed by concerns over U.S. protectionism. Yen-buying also tend to be strong around this time of the year 

Unclear why Kuroda made specific comments about monetary exit when downward pressure on USD/JPY was already in place. May need to closely watch what Kuroda says after the BOJ policy meeting next week 

ING Bank NV (Rob Carnell, chief economist for the Asia Pacific) 

Kuroda has "done as well as you could possibly imagine with the tools he's had. He's used them imaginatively and aggressively. Has it worked? Not entirely. Do you blame him for that? Not really." 

"If you set ambitious targets and miss them, but get halfway, that's better than setting unambitious targets and missing them and not getting there" 

"Japan no longer feels like it's flirting on the edge of a dangerous deflation cliff" 

When the European Central Bank begins to formally normalize its own monetary policy, it may provide a window for the BOJ to act as well; "You don't want to be the odd-man out in this game" 

Asymmetric Advisors Pte (Amir Anvarzadeh, strategist) 

"First timeline by Kuroda-san as BOJ's QE looks to start tapering. We expect upward pressure on the long-end and BOJ to steepen the curve as it reduces purchases of the longest-dated paper" 

"We think this scenario bodes well for the banks and other financials" 

Bank of America Merrill Lynch (Shusuke Yamada, chief Japan foreign-exchange and equity strategist) 

"Kuroda's comments could spur speculation among some traders and investors that the BOJ may start discussing an exit strategy now in order to enter into the exit" then 

"He's just trying to keep a policy option in the future -- he could fine-tune the policy before achieving the 2% goal, or he would not do so even after reaching the goal" 

"The stock market may be wary of gains in the yen, which would make it difficult to lure purchases from foreign investors.

Zero Hour: The Greatest Political and Economic Revolution Since Democracy Itself

A look into the new book, Zero Hour: Turn the Greatest Political 

and Financial Upheaval in Modern History to Your Advantage.

The Great Boom Ahead put me on the map with breakthrough

demographic indicators and forecasts that tagged the whole

decade of the 1990s. The Roaring 2000s sold over 800,000

copies and introduced its own breakthrough concept:

the "network corporation," characterized by bottom-up, 

not top down, management.

Zero Hour brings together all of the breakthroughs had over

the years, and then adds to them with, among other things,

the discovery of a rare convergence of three-long term cycles

that point to a revolution. A true revolution, like the Industrial

and American Revolutions that brought together the twin

breakthrough concepts of democracy and free-market capitalism.

It was a discovery only possible with extensive collaboration

with my co-author Andrew Pancholi – the only other guy in 

the world who knows as much about cycles as I do.

Chart: Megatrend #1: The Three Harbingers of Revolution

Today, we're seeing the greatest political polarization

since the Civil War, a debt and financial asset bubble 

that makes the Roaring 20s look like child's play, and

income inequality greater than that experienced in 1929.

But most important, we're seeing breakthrough 

technologies, like the internet, and blockchain to come,

that will change business and politics as we know them.

Biotech and related technologies promise to greatly extend 

life spans and finally reverse the never-ending demographic

decline the world is now facing.

No mainstream economists saw the greatest boom in 

history before it struck, nor the dramatic collapse of Japan.

None have seen this sweeping revolution, which will go

down in history as the one that literally reshaped the world

map, politics, economies, stock markets, and lives!

Trump and Brexit are only the first signs of much more to 

come – and this revolution will not end like it starts – trust 

me on this.

And as if that weren't enough, look at this megatrend that's

about to descend on the global economy. The second

great surge in globalization has peaked and will see a major

retrenchment for decades (not just years) ahead.

Chart: Megatrend #2: The Second Explosion in Globalization 

Has Peaked

The first surge occurred with steamships and then railroads

before colliding with World War I, the Great Depression,

and World War II… all major political and economic events

that no one saw coming!

Global trade retrenched 60% over 33 years – that's a big deal!

The technological and network revolution ahead driven

the internet and blockchain technologies will finally create

the breakthroughs for the third and final great globalization

surge that will take the world to 90% urban and middle class.

Will Italy’s Banking Crisis Spawn a New Frankenbank?

"Operation Overlord."

There are rumors currently doing the rounds that Italy's banking problems have finally been put to rest. The FTSE Italia All-Share Banks Index has soared about 40% over the last 12 months, about double the advance by the Euro Stoxx Banks Index. Six of the top seven gainers in the latter index this year are Italian.

The story of Italy's non-performing loans, which just a year ago terrified global investors and posed a systemic threat to the entire Eurozone economy, "is over," according to Fabrizio Pagani, the chief of staff at Italy's Ministry of Economy and Finance. Pagani believes that now that the banking sector is well and truly on the mend, work should begin to take consolidation of the sector to a new level.

"There are too many banks," Pagani told Bloomberg. "And in this sense, Monte dei Paschi could play a role. I think this could start this year."

There's clearly lots of room for consolidation in Italy, home to roughly 500 banks, many of which are small local or regional savings banks with tens or hundreds of millions of euros in assets. At the top end of the scale, Italy's ten biggest banks control roughly 50% of the industry. The goal is to increase thatto 70-75% to bring it more in line with the levels of banking concentration in other EU countries. In Spain, for example, the five biggest banks — Santander, BBVA, CaixaBank, Bankia and Sabadell — control 72% of the market.

The problem is that, while last year's bail out of Monte dei Paschi di Siena may have restored a certain amount of investor confidence to Italy's banking sector, many of the largest banking groups are still extremely fragile, with stubbornly high non-performing loan (NPL) ratios. Even Intesa Sanpaolo, which is widely regarded as Italy's most stable large bank, had a bad-loan ratio of 13% at the end of September, compared to a European average of 4.5%.

As such, trying to find suitable merger partners that are not going to drag each other further down is not going to be an easy task. Intesa is still trying to digest tens of billions of euros in assets from Banca Popolare di Vicenza and Veneto Banca, the two mid-size collapsed banks it gobbled up at the government's insistence in June last year. As for Unicredit, Italy's only global systemically important bank (G-SIB), it's barely back on its own two feet after successfully completing the biggest ever capital expansion in Italian history last year.

So, if the two biggest banks are most likely out of the equation for now, who could Pagani be thinking about? For the moment he says it's too early to say.

But while Pagani keeps mum, Giovanni Razzoli, an analyst at Equita SIM, has identified five potential suitors — Monte dei Paschi di Siena (now majority owned by the State), Banco BPM, BPER Banca, Credito Valtellinese and Banca Carige — that could be merged into one mega-bank. He's even given his masterplan a name, with suitably dark undertones: Project Overlord.

Three of the banks have one obvious thing in common: they have all been, or are in the process of being, rescued, either by taxpayers or shareholders, or a combination of both.

Despite being bailed out with €8.5 billion of taxpayer funds last year, in contravention of new EU rules on banking resolution, Monte dei Paschi is still far from out of the woods. In early February the bank reported total losses in 2017 of €3.5 billion, as a result of falling revenue, loan write-downs, and one-off charges. Since then its stock, which resumed trading on Oct. 25 after a 10-month hiatus, has tumbled over 15%. Now valued at €3.18, the shares are 51% below the €6.49 that Italian taxpayers paid during the latest rescue.

Then there's mid-sized lender Carige, with assets of €26 billion. In December it completed a €500 million share issue that very nearly flopped. Together with a completed exchange of subordinated bonds into senior bonds and ongoing asset disposals, the capital increase is expected to raise about €1 billion of capital, according to rating agency Moody's. The proceeds will largely be used to write down and then dispose of €1.9 billion of problem loans.

Credito Valtellinese (or Creval) is in a similar situation having reported a €332 million loss for 2017 in preparation for its own €700 million rights issue. Since then its shares have tumbled from €0.16 to €0.11 cents.

In other words, Operation Overload would involve joining at the hip three banks that are barely capable of standing on their own two feet, even with all the public and/or private support they've received, with two other banks — one of which (Banco BPM) is barely a year old after being spawned from the merger last year of two large cooperative banks, Banco Popolare and BPM.

For an indication of what could ensue one need only recall what happened to Spain's very own frankenbank, Bankia, which was created in 2010 by melding together six failing regional savings banks with a larger and seemingly healthier lender, Caja Madrid. Less than a year after its public launch, in 2011, Bankia collapsed in such emphatic style that, to be reanimated, it needed the biggest ever public bailout in Spanish history.

One can only hope that Italy's incoming policymakers and Europe's central bankers have learnt enough from recent history to consign Project Overlord to the dustbin. But if recent history has taught us anything, it's that policymakers, whether in government or central banking, rarely learn from history. 

There's a new plan to deal with the problems of Spanish banks, but there's a problem with the plan.

Why falling interest rates could be bad for stocks

Below looks at 2, 5, 10 & 30-year yields over the past 30-years. Yields remain inside of respective 25-year falling channels. Rallies over the past couple of years has each testing the top of these falling channels.

CLICK ON CHART TO ENLARGE

When the tops of each falling channel were last touched in 2000 & 2007, yields declined and so did stocks.

Many have been concerned about rising rates. Should stock bulls now be concerned about rates falling at each (1)?

If they use these channels as guides, they should be!

A Market Crash Flowchart

On February 5, a 28-sigma surge in VIX driven by a massive short squeeze in inverse VIX ETFs, catalyzed a 1000 point Dow drop, leading to the worst week for stocks in years.

Yesterday, Trump's unofficial declaration of trade war - or at least the intent thereof - has sparked another 500 point Dow drop, just as the "experts" were giving the all clear .

However, while both events have discrete causal factors, what is behind the recent market instability is neither a Vol problem nor a trade problem, but a "years of pent up ultra low rates" problem, which after years of central bank vol suppression and market manipulation, is finally manifesting itself.

As Deutsche shows in the chart at the bottom, the background of the risk-off shift started in January, with the Trump administration's moves to depreciate the dollar ahead of mid-term elections, together with a shift of the type of interest rate rise from favorable to unfavorable, which in turn triggered the drop in share prices and the dollar. Deutsche describes the rise in rates that triggered risk-off as "unfavorable rise".

Reflecting the sudden reflationary burst, 10y UST yields rose sharply from 2.32% on 22 November 2017 to 2.92% on 22 February. As a result, DB's US rates research team raised its end-2018 10y UST forecast from 2.95% to 3.25%, and sees further upside potential in the terminal real rate of Fed funds, the inflation risk premium and the term premium. It is also possible that a sudden burst of inflation could hit asset prices, as in the 1960s.

And while higher rates initially catalyzed the move lower in risk assets, stocks have subsequently been more influenced by the VIX. As shown in the chart below, recently the S&P500's P/E (more specifically, its risk premium) was determined by VIX.

Therefore, during a period when higher interest rates cause higher VIX, stock prices should fall. As DB explains, since 5 February, higher (lower) VIX has led to lower (higher) rates.

Putting it all together, Deutsche provides the following flowchart to explain why your net retirement account is suddenly a few percent less.