Eurozone’s next big threat: Italian banks

Forget bonds and European banks. Buy gold.

That’s the recommendation of Jeffrey Gundlach, who is the latest to wear the crown of “Bond King” as his $US100 billion DoubleLine Capital continues to notch up strong performance.

“Things are shaky and feeling dangerous”, Gundlach said in a telephone interview with Reuters this week. “I am not selling gold”.

Gundlach predicted that the precious metal would rise to $US1,400 an ounce this year (from its present level of around $US1,360 an ounce), adding that gold bullion and gold-related stocks were attractive compared to US government bonds.

The yield on the 10-year Treasury note edged higher to close at 1.39 per cent overnight, after hitting the lowest level on record in Wednesday trading. (Yields fall as bond prices rise)

“If you buy 10-year Treasuries now, I would say, it is a terrible trade location. It is the worst trade location in the history of the 10-year Treasury.”

Gundlach was also pessimistic about the European banking system, which he said was “in a state of heading toward insolvency.”

Italian banks have seen their share prices tumble in the wake of the Brexit vote. Investors fear that Italian banks represent the next explosive challenge for the eurozone, one that will sorely test the credibility of policy-makers’ efforts to forge a banking union.

Italian banks are sitting on a huge pile of problem of problem loans – which are either behind in their interest payments, or which have stopped paying interest altogether – which are estimated at about €360 billion ($533 billion), or around 20 per cent of their loan books.

While these soured loans remain on their books, banks are reluctant to lend, and investors are nervous about buying bank shares.

Prime Minister Matteo Renzi has come up with a plan to inject €40 billion of government money in an effort to prop up the country’s embattled banking sector. But Brussels is opposed to the scheme because it contravenes new eurozone “bail-in” rules that require bank shareholders and bondholders to suffer losses before taxpayer money is used.

These rules, however, are politically unacceptable to Renzi, because small retail investors hold large quantities of the lower ranking bonds issued by Italian banks, and their investments would be wiped out if the “bail-in” rules are applied.

But Italian banks aren’t the only cause for concern. Gundlach also pointed to Deutsche Bank, whose share price has halved since the beginning of the year. Overnight, Deutsche Bank share dropped a further 0.9 per cent to close at €11.44.

“Banks are dying and policymakers don’t know what to do”, Gundlach warned. “Watch Deutsche Bank shares go to single digits and people will start to panic….you’ll see someone say, ‘Someone is going to have to do something’.”

Gundlach’s warning comes as the European Commission overnight took the unprecedented step of declaring that Spain and Portugal have failed to meet their obligations under the eurozone’s budgetary pact.

The declaration opens the way for financial sanctions, at a time when both countries are facing enormous political strains. Spain is still without a stable government, while Portugal’s leftist anti-austerity coalition government, which came to power last November, is adamant that it should not be forced to pay for the decisions taken by the previous conservative administration.

There’s little doubt that both Spain and Portugal are slipping in their efforts to rein in heavy budget deficits.

In 2015, Madrid ran up a budget deficit that came to 5.1 per cent of GDP, well above the 4.2 per cent that Brussels was expecting. Lisbon’s budget blew out to 4.4 per cent of GDP, instead of the 2.7 per cent forecast.

But Brussels faces a difficult decision in deciding what sanctions should be imposed. In theory, the fine can be as much as 0.2 per cent of the country’s GDP, but most observers believe that Brussels is more likely to recommend a small fine, or even no fine at all.

This would signal that while Brussels acknowledges that both countries suffered heavily from the financial crisis, and have endured years of austerity. More importantly, it would indicate that Brussels is wary of stirring up more instability in European markets, which have been rattled by the Brexit vote.

But if Brussels is too lenient, it will face criticism from Germany, the Netherlands, and the European Central Bank, which believe that maintaining budgetary discipline is essential for the region’s stability.

The author: Michel DEURINCK

Michel Deurinck, born in Brussels in 1950, started his career in the Belgian civil service, dedicating over 30 years to public service. Upon retirement, he pursued his passion for journalism. Transitioning into this new field, he quickly gained recognition for his insightful reporting on politics and culture. Deurinck's balanced and thoughtful approach to journalism has made him a respected figure in Belgian media.

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