Italy Announces Inevitable Bank Bailout

After Monte Dei Paschi di Siena (MPS) failed to raise enough money for a private recapitalization, the Italian government finally pulled the trigger on an inevitable bailout.

Early Friday morning following a cabinet meeting, caretaker Prime Minister Paolo Gentiloni announced an emergency decree to rescue the troubled bank. As part of the plan, the government will provide protection to 40,000 retail investors who own around 40%, or 2 billion euros worth, of MPS bonds. MPS shares tumbled nearly 10% Monday amid doubts about its recapitalization plan, with Qatar's sovereign wealth fund reportedly pulling out as the deal's anchor investor. In response, the Italian government received permission Tuesday from parliament to create a 20 billion-euro rescue fund for the country's stricken banking system. Part of the money will be raised through fresh sovereign bond issuance even though Italy's public debt, at 2.23 trillion euros, is the second-largest in Europe as a percentage of GDP.

Rigid euro zone banking rules have prevented a wider bailout of the region's banking system, which is saddled with 356 billion euros of bad loans. European officials have reportedly approved the Italian plan in hopes of heading off further contagion. The Monte Dei Paschi bailout almost certainly won't be the last in Italy. Banks including Veneto Banca SpA, Banca Popolare di Vicenza and Banca Carige SpA will likely follow similar templates in receiving public funds.

As you might expect, the loudest objections to the arrangement are coming from Germany. Christoph Schmidt, the head of Chancellor Angela Merkel's council of independent economic advisers, said the bailout "should be achieved under the agreed rules, meaning the creditors must contribute to its rescue, not the taxpayers." However, there is precedent for creatively structured bail-ins. In 2012, to absorb sour loans Spain's government put together an asset-management company, which then imposed losses on junior bondholders as mandated by EU rules. The government then reimbursed retail investors who had unwittingly bought the risky paper. Italian officials are pushing healthier financial institutions to join forces to create a similarly structured asset management firm, Atlante.

While the MPS bailout calms nerves about an imminent financial crisis, it does little to solve underlying problems in Italy's banking system. Bloomberg estimates the Italian finance sector would have to increase loan-loss provisions by 52 billion euros to allow for the sale of bad debt. While banks including Unicredit could privately raise around 22 billion euros, the public rescue fund will likely need to grow by another 10 billion euros (to 30 billion) to fully address the hole in Italian bank balance sheets.

Europe has kicked the can down the road again, but political uncertainty and worsening demographics could prevent the continent from truly overcoming its massive debt problems.

Yuan Weakness, Capital Flight Causing Problems In Chinese Debt Market

Capital flight and volatility in the Chinese bond market is finally starting to hurt companies' ability to raise debt.

China Central Depository & Clearing said 20 firms called off bond offerings totaling nearly 20 billion yuan between December 14 and 16. The recent bond rout has been driven by faster-than-expected capital outflows from mainland China. The People's Bank of China (PBoC) reported a $540 billion reduction in foreign currency reserves from August 2015 through November 2016, but a team of Goldman Sachs analysts believes the real currency-adjusted figure is closer to $1.1 trillion.

While China has stepped up efforts to curb capital fight, investors are wagering on yuan depreciation more aggressively than ever. Forward contracts betting on a cheaper yuan are headed for a record monthly jump, while option premiums to sell the currency are at a six-month low. Implied probability of the yuan being weaker than seven per dollar by the end of Q1 2017 is now greater than 50%. A Goldman Sachs macro research team has long USD/CNY as one of its top trades of 2016, laying out a scenario that would spell trouble for global stocks.

Contributing to rising bearishness on China are recent appointments to the Trump Administration's economic team. Last week, the president-elect tapped noted China critic Peter Navarro to head the new White House National Trade Council, which will run trade policy for the new administration alongside Commerce Secretary Wilbur Ross, another China hawk.

Chinese foreign ministry spokesperson Hua Chunying warned the incoming U.S. administration about the dangers of rocking the boat. "As two major powers with broad mutual interests, co-operation is the only correct choice," she said Thursday. The Chinese military conducted additional exercises this weekend designed to send a message of strength to the incoming administration.

While attention during the campaign focused on Russia and the Middle East, the most volatile relationship with the greatest implications for the global economy over the next decade is between the United States and China.

Deutsche Bank Reaches Settlement With DOJ

Deutsche Bank finally struck a deal with the U.S. Department of Justice (DoJ) over its packaging and sale of toxic mortgage securities in the lead-up to the 2008 financial crisis.

The German bank agreed to pay $7.2 billion - a $3.1 billion penalty and $4.1 billion in relief to American consumers - to remove one of the last remaining black clouds over the institution. Shares rallied around 4% given the final sum was nearly half the leaked $14 billion figure being sought by the DoJ when negotiations began this summer. Deutsche Bank reportedly does not plan a capital increase to cover the settlement. DB stock is still down around 25% on the year but up more than 60% in the fourth quarter as a liquidity crisis appears temporarily averted.

The DoJ also agreed to a $5.3 billion settlement with Credit Suisse in a similar case, while announcing a new mortgage-related lawsuit against Barclays. The U.S. government has reached $46 billion in settlements with global banks over the last three years.