By Dhara Ranasinghe
LONDON (Reuters) - If a chain is only as strong as its weakest link, euro zone authorities need to act fast to support Italy and its banks, which are coming under strain from the surge in sovereign borrowing costs and an economy tipping into recession.
Already the bloc's most fragile economy, Italy has been dealt a blow by the coronavirus outbreak that has forced it to order a virtual lockdown across much of its wealthy north, including the financial capital Milan. It is the worst-hit country in Europe, with the death toll continuing to rise.
But banks are emerging as the focal point. Economic recession will sour their loan books but a bigger problem for now is their exposure to Italian government bonds -- the so-called doom loop, whereby a selloff on government debt circles back to banks because of their holdings.
On Monday, Italian banking stocks slid more than 12 percent and investors rushed to insure their exposure to the sector, driving up credit default swaps (CDS) for banks such as UniCredit and Intesa Sanpaolo (MI:ISP) by more than 40 basis points.
"Italy is a fault line across the European financial and economic system," said Paul O'Connor, head of the multi-asset team at Janus Henderson. "It is the last place you needed to see this adverse economic shock. We have a weak economy and a banking sector that's already showing frailties."
Monday's dramatic moves followed a blow out in the closely-watched 10-year bond yield gap between Italy and Germany to more than 200 basis points for the first time since August. Essentially that is a gauge of the premium investors demand to hold Italian risk.
The spread was around 45 basis points wider than levels seen late on Friday, marking the biggest widening since a political crisis in May 2018 sparked a rout in Italian bonds.
If yields on Italy's government bonds rise further, banks holding them lose money. They might be inclined to sell their holdings, in turn putting upward pressure on sovereign borrowing costs.
Despite the introduction of tougher banking regulation and oversight in the wake of the euro zone debt crisis a decade ago, the doom loop remains.
Italian banks held 388.22 billion euros of Italian government bonds in their portfolios at the end of January, around a sixth of the country's public debt.
"The feedback loop between the sovereign and banks in Italy is alive and well, and both sovereign and bank debt should trade in lock-step," said Antoine Bouvet, senior rates strategist at ING.
Banks were dominant players in short-dated Italian government bonds or BTPs, he noted, adding this is where Italian default risk is most clearly priced.
Indeed, two-year bond yields soared more than 50 bps at one point on Monday; they were last up 32 bps at 0.38%.
Five-year CDS for Italy jumped to 219 bps, their highest level since June.
Graphic: No breaking the doom loop; Italian spread vs bank stocks https://fingfx.thomsonreuters.com/gfx/mkt/13/3065/3030/IT0903.png
Graphic: Italian banks' holdings of BTPs https://fingfx.thomsonreuters.com/gfx/mkt/13/3064/3029/banksbtps.png
RESCUE MISSION
That building stress means Italy will at the forefront of policymakers' minds when the European Central Bank meets this Thursday. Markets are betting on a 10 bps interest rate cut but that's not what Italy needs, given euro zone rates are already at minus 0.5%.
According to source-based reports the ECB is also preparing measures to provide liquidity to euro zone businesses.
"Looking at the price action in BTP and credit, it is clear to us that markets are testing the ECB's resolve and are trying to force an acceleration of bond purchases," ING's Bouvet said. "At this stage, this is the only ECB measure that could restore confidence."
One idea under discussion is a targeted longer-term refinancing operation (TLTRO) -- loans on favourable terms for banks that require them to lend to households and businesses -- directed at small- and medium-sized enterprises.
But the selloff in Italian bonds also means that a ramping up in controversial asset purchases is more likely, say economists.
"I would expect the ECB to focus on alleviating liquidity tensions and facilitating the flow of credit, and that will imply measures such as TLTROs," said Janus Henderson's O'Connor.
"QE (quantitative easing) is powerful when you want to push bond yields lower. They started QE when Italian bond yields were 6-7% but that's not the case now."
Marija Veitmane, senior strategist at State Street (NYSE:STT) Global Markets, said the negative-rate backdrop has kept her negative on European banks but that Italy was a particular concern.
German bank CDS also rose sharply on Monday as German bond yields moved further into negative territory, creating more pain for domestic banks there.
"Specifically on Italy and their assets, the banks become a very interesting space to watch given their high holdings of BTPs and the high level of NPAs (non-performing assets). But the ECB is on standby so we have to wait and watch."
Graphic: Italy NPLs https://fingfx.thomsonreuters.com/gfx/mkt/13/3063/3028/Italy%20npls.png
