An inadvertent Christmas gift from France to Italy .... and it's getting trickier for the Fed ..

As we start the last full week before the Christmas break, two things being widely discussed across the financial media outlets catch the eye in particular. Two things beyond the usual avalanche of comment about Brexit and the trade war , that is. First up is Italy and news that the populist deputy prime ministers, Matteo Salvine of the League and Luigi Di Maio of Five Star, have both signed up to PM Conti's revised budget proposals.

Italy will now submit a plan to the EU that will show a 2019 buget deficit-to-GDP ratio of 2.04% ....., a significant reduction from the original 2.40%. The market seems happy enough with Italy's new position, and the premium of the yield demanded on Italian 10yr debt over its German counterpart is at 269 basis points, down from the five-year high of 327 bp seen when Rome presented its first and plainly unacceptable proposal to the European Commission. The new-found willingness to consider at least some compromises comes as a reassurance to those holding Italian bonds.

Insiders say that the EC are likely to accept Italy's offer "so long as policy details are rigorous enough and the economic assumptions are reasonable". Anyone spot the obvious danger ? Yes, quite takes quite a leap of faith to accept Italy's own growth projections which they say are going to boost income. Come to think of it, it takes quite a leap of faith to accept the the numbers in the new proposal as they stand : the coalition have refused to contemplate any changes to the pillars of their policies, a citizen's income for the poor and a lowering of the retirement age, and quite how they've managed to cut welfare payments from €9 billion to €7.1 billion and at the same time find an extra €3 billion in cash has not been fully explained.

Mathematicians may have their doubts, but the likelihood of the proposal being accepted by the EC is only increased by recent developments in Paris. In order to bring an end to the protests of the "Gilet Jaune" movement, President Macron plans to introduce measures that will cost a net €10 billion .... and in doing so breach another of the rules laid down by the Commission. Just to be clear :

Theoretically, Italy is in breach of the utterly outdated and unrealistic rules regarding the ratio of total debt to GDP .... the rules say that no nation should have a debt level of more than 60% of GDP. Post-crisis, the average debt level of Euro-area nations is much higher, currently about 95%. In fact, these rules have NEVER been strictly applied. The point about Italy however is that at over 130% of GDP (second only ot Greece) their debt was getting out of control, particularly with regard to interest payments, and an agreement had been struck with the previous government that it would lower that figure. By doing away with the previous administration's plans for a 2019 budget deficit-to-GDP ratio of just 0.8% and replacing it with one of 2.4%, Italy was clearly going back on the deal and were more likely to exacerbate the problem than address it.

As things stand, France's extra spending will take their 2019 budget deficit-to-GDP ratio to 3.4% ..... it is likely that some compensatory spending measures will be found, but not enough to take the annual budget deficit figure below the 3% of GDP that the rules require.

This rule (like so many others) has been breached many times by both France and others, but on this occasion the timing could be very handy for the Italians. It would be extremely difficult for the EU to allow France to break one rule (which they almost certainly will), and then penalise Italy for breaking another .... especially after they've gone some way to compromise. One may not have a lot of confidence in the accuracy of Rome's numbers or predictions, but such concerns may well be sacrificed on the altar of political expediency. In Europe, for better or for worse, it was ever thus .....


Tomorrow sees the start of the US Federal Reserve's two day monetary policy meeting .... with the decision on interest rates and Fed statement coming at its conclusion on Wednesday. Futures markets suggest that the probability of a 25bp hike remain very high, at about 78%. This is despite a growing list of ostensibly doveish factors : trade conflict, slowing global growth, Brexit, stock market reversals .... and a lack of inflationary concerns despite very tight labour markets.

Assuming the 1/4 point rise is confirmed, the main interest will be in what Chairman Jay Powell has to say and what the "dot-plot" reveals about how individual FOMC members view (anonomously) the course of rates in the future. Up until now, the mean view of the FOMC (Fed Open Market Commitee) has been three hikes in 2019 .... along with the language used by the Fed, that forecast seems likey to change. A survey of Wall St. economists released at the weekend points to two rate rises of 25bp next year, and the market (as judged by futures market prices) sees barely one. So prepare yourself for something altogether more cautious from the Fed ....

On the other hand ..... in spite of all the adverse factors that Mr Powell has acknowledged recently, he has also pointed out how the domestic economy continues to perform strongly. He'll also be bracing for a broadside from President Trump should a rise be confirmed on Wednesday, and the irony in that is that because the Fed would never want to be seen to kowtow to politicians, Mr Trump's rantings may make future rate hikes more rather than less likely.

The point is .... everyone is (quite rightly) expecting a so-called "doveish" hike, with doveish statements and a more cautious outlook for the future. It's quite possible therefore the more likely surprise (if there is to be one) might be if the Fed maintains more of its upbeat position than the market now expects it do.

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