Italy’s No vote in last week’s referendum on constitutional reform was supposed to be the next nasty market surprise after Brexit and Trump. Instead, stocks, bonds and currencies all produced “a jaw-breaking yawn”, says The Economist. That wasn’t only because the markets had priced in the result as none of Italy’s problems are remotely new. The key reason is that investors thought “the European Central bank (ECB) would act to stem any panic”.
Had the markets reacted by selling off Italian debt, sending yields, or implied borrowing costs, to eye-watering levels, the ECB could have stepped up the pace of its quantitative-easing programme, whereby it buys government bonds with printed money. That would drive up the price and lower yields (which move inversely to prices), alleviating the pressure on the government and averting potential bankruptcy.
There was no panic, but the ECB made it clear that it will be “providing an exceptional level of monetary support for many years to come”, says Capital Economics. It said it would extend QE by nine months, although it will buy e60bn a month, rather than the current e80bn, from April. By the end of next year, its QE will total 25% of GDP, the same as the Bank of England’s. And while the original plan had been to start tapering off support from September 2017, now ECB President Mario Draghi says he will keep going beyond December 2017, if necessary. So if there is a panic, he can up the pace again. If the ECB now follows the Fed’s tapering and rate-hiking path, it won’t raise rates until 2019.
This endless money printing is supposed to buy politicians time to patch up the design flaws in the single currency and galvanise growth. But they haven’t, and the euro looks increasingly vulnerable to a violent rupture. “One day”, as the FT’s Wolfgang Munchau points out, a party in favour of withdrawal from the euro will lead Italy. While the ECB could counteract a sell-off triggered by fears of withdrawal, things could slide out of control once Italy decides it’s had enough. If it brings back the lira, it would imply a huge default on its euro debt, decimating the German banking system. Alternatively, Germany, under mounting pressure from populists, could eventually force the ECB to stop propping up the periphery.
In short, it’s hard to see how the ECB can keep up its support forever. But with inflation still some way off its target of just below 2%, it can certainly keep it up for now. In the meantime, the slow but steady European recovery, along with the weak euro, bodes well for earnings and equities – until the next panic, that is.