The first warning tremors of another eurozone debt crisis can already be felt, before the European Central Bank even begins to lift interest rates from sub-zero levels.
Risk spreads on Italian 10-year bonds have broken through 200 basis points, approaching the red flag levels seen when anti-euro populists swept the elections in 2018.
They are higher today than when premier Mario Draghi was drafted by the Italian political elites to restore economic credibility.
Mr Draghi is fully alert to the danger. “The spreads have been rising in a lot of European countries. This does not disguise the fact that we’re starting from a higher base, and from a public debt stock that is much higher,” he said last week.
And he had a warning for those who think his presence alone can ward off the bond vigilantes. “I am not a shield against any event: I am human to whom things happen,” he said.
Italy is the most salient casualty of the global bond sell-off this year, the country most threatened as the big central banks step up the pace of monetary tightening.
This tightening has a particular character in the eurozone’s half-completed currency union, where states no longer have their own sovereign lender-of-last resort, and no longer borrow in a currency that they can print.
This makes the end of quantitative easing more treacherous in Europe than anywhere else, especially for Italy with a public debt to 151pc of GDP. This is up from 134pc before the pandemic, and up from 120pc in 2011 when it blew up last time. This level is uncharted territory for a major sub-sovereign borrower.
The rising debt ratio has until now been academic. The ECB has been soaking up Italy’s debt issuance and suppressing market risk. It has purchased €4 trillion (£3.4 trillion) of eurozone assets, including €722bn of Italian public debt - almost 40pc of Italy’s GDP.
ECB bond purchases are tailing off rapidly and will probably end in June, exposing Italy to a market shock just as it struggles with soaring energy costs and a fresh recession.
Foreign investors have been running down their holdings. It is not clear who will step in to buy the debt, or at what price. Italy must redeem €226bn of outstanding debt this year, €254bn in 2023, and €251bn in 2024.
Inflation helps to whittle down the real debt burden. However, the budget is nowhere near structural balance. Fitch forecasts a deficit of 5.5pc of GDP this year and 4.4pc next year.
Goldman Sachs said last month that bond markets had yet to “price” the new reality. They are pricing it now. Italy’s 10-year yields have risen 109 basis points to 3.14pc since then. The risk spread over German Bunds has jumped 50 basis points.
The Bank of Italy’s Stability Report warned of a sharp rise in “implied volatility” for Italian debt, and a surging “bid-ask” spread as liquidity dries up.
Italy is doubly exposed because markets are also starting to price in life after Mr Draghi, aware that unelected technocracy cannot go forever and that Italian democracy must have its say by June next year.
The polls point consistently to a hard-right eurosceptic government led by Fratelli d’Italia (Brothers of Italy). Party leader Giorgia Meloni has an almost identical platform to France’s Marine Le Pen, but in a country with a different political anthropology.
Fratelli leads at 22pc in the latest Dire poll. This would give her a parliamentary majority under Italy’s electoral system, linking up with the nationalist Lega (15pc) and Silvio Berlusconi’s Forza Italia (11pc), possibly one of such clarity that the pro-Europe president would struggle to veto its policies.
Meloni’s manifesto calls for a “confederation of European federal states, a rejection of EU fiscal rules, an end to the exploitation of the EU as a Franco-German “playground”, and the explicit promotion of Italy’s Christian identity.
This has to be taken with a pinch of salt. What is clear is that a Fratelli-Lega government would be in conflict with Brussels over the Stability Pact and the EU machinery of fiscal surveillance. The clash would irritate the northern creditor states and kill attempts to turn the €800bn Covid Recovery Fund – little to do with Covid in reality – into a permanent ‘fiscal entity’ or proto-EU Treasury.
The ECB’s doves under Christine Lagarde have been trying to delay the end of QE, valiantly calling it monetary policy when it looks to most like a debt shield for insolvent Club Med states. “It’s pure fiscal dominance,” says Thomas Mayer, Deutsche Bank’s former chief economist.
This has become untenable as eurozone inflation hits 7.5pc, and reaches 40-year highs in Germany. A growing chorus of German economists protests that the ECB has been captured by the southern debtor bloc, and that the ECB’s staff is in thrall to Modern Monetary Theory. Otmar Issing, the ECB’s founding guru, told a Frankfurt forum that the bank was living in a “fantasy world”.
The ECB’s northern hawks are spoiling for a fight. Austria’s governor Robert Holzmann is calling for three rate rises this year. It is the same refrain from Finland and the Netherlands.
Isabel Schnabel, Germany’s member on the executive council and a political bellwether, has suddenly switched sides. “We need to prevent high inflation from becoming entrenched in expectations. Talking is no longer enough, we need to act,” she told Handelsblatt in a fire-breathing interview last week.
She talked of ending all QE asset purchases by late June, and suggested a rate rise – from minus 0.5pc – as soon as July. The warning to markets could not be clearer.
The ECB thinks it can continue to protect Italy come what may, chiefly by switching ever more of its existing portfolio into Italian debt as old bonds expire.
But this implies accumulating most of Italy’s national debt over time. It runs into serious technical, legal, and political limits. Fabio Balboni from HSBC said the markets are likely to “test” this defence.
The ECB staff have been working on a further anti-spread weapon for months, but this has yet to see the light of day, probably because it violates the Lisbon Treaty’s no-bail clause. The scheme will face an inevitable challenge at the German constitutional court.
If all else fails, there is a final “nuclear option” to back-stop Italy’s debt. It was designed by Mr Draghi himself when he ran the ECB a decade ago.
It is composed of loans from the EU bail-out fund (ESM), which can then trigger targeted bond purchases by the ECB as a supporting measure. But the rescue package requires the approval of the German Bundestag and other parliaments. The conditions would be draconian.
The instrument has yet to be ratified in Rome because of resistance from the political right. A Fratelli-Lega coalition would be loath to activate the process until Italy was on the brink of default. By then the contagion spreading through Spain, Portugal, and the rest of Club Med would risk a replay of the debt crisis in 2011.
In a sense, Italy has been in suspended political animation since 2018, when voters elected anti-euro parties of left and right in a primordial scream against the status quo.
The establishment poteri forti found ways to finesse this over time, ultimately installing a technocrat government more to their liking under the quintessential Mr Euro, with no elections along the way to legitimise this 180-degree reversal. They have not yet found a way to abolish voting altogether.
Italian political risk is back on the table, just as the ECB debt shield disappears.