The European Central Bank (ECB) kept interest rates artificially low for a long time, but financial repression has its limits. The combination of rising US interest rates and increasing political instability in Italy are pushing down the euro. Higher interest rates in Europe are the natural result, but deeply indebted eurozone governments might not be able to pay. This could be the beginning of a new European sovereign debt crisis.
Italy's interest rates shot up over the last several months as the new populist coalition government called for debt relief and even considered plans to exit the euro. Italy's 10-year government bond yields climbed from less than 1.8% to over 3.4% before falling to 2.6%. Remember that you can get 2.9% ten-year bond rates right here in the USA with a dramatically lower risk of default and zero chance that America will abandon the dollar. Italy's interest rates will have to rise even more to compensate for the higher risk.
The recent decline in the euro is both a sign of waning confidence in the single European currency and a threat in its own right. The euro was in a long-term uptrend, going from $1.04 in late 2016 to about $1.25 earlier this year. European interest rates have been able to fall while US rates rose because increasing confidence in the future of the euro was causing the euro to rise, compensating investors for the lower rates. However, the lure of higher interest rates in America and declining confidence have pushed the Euro down more than 7% over the last three months to around $1.16.
We are also now in the summer months, which have historically been very unfavorable for European government debt. Greece missed interest payments in July of 2015, and Russia defaulted on its national debt in August of 1998. This time is different: Italy's national debt is much bigger. Italy has the third largest national debt in the world, equivalent to over 2.6 trillion US dollars. As a standard of comparison, Greece's national debt is equal to about 400 billion dollars. It is an open question whether the ECB, the IMF, or anyone else could bail out Italy.
The potential disaster in Europe could easily cause the Fed to reverse course on interest rates. That is exactly what happened when Russia defaulted in 1998. If the Fed reduces rates, we are likely to experience higher inflation here in the USA. The Fed faces a difficult choice. Higher inflation at home or a new European debt crisis? Fortunately, gold is an easy choice for individual investors. Gold is a superb hedge against inflation, and it also does well when governments default on their debts. Regardless of which path the Fed chooses, gold provides protection.