With stocks in Europe attempting a modest relief rally after yesterday's sharp selloff, traders remain on edge over political developments as today is the deadline for Italy's cabinet to resubmit their budget proposal after the EC requested a new fiscal plan. Virtually nobody expects any material changes, especially with Il Sole reporting this morning that Italy will maintain its 2019 deficit target at 2.4% of GDP and could alter the 2019 GDP growth rate of 1.5%

When looking at next steps, Deutsche Bank economists yesterday concluded that as contagion has been relatively limited for now, the commission will continue to adopt a tough stance on Italy which will be found in breach of European Union fiscal rules, and it now seems inevitable they will recommend an Excessive Deficit Procedure (EDP) in the next few weeks.

And speaking of Deutsche Bank, the German lender's Head of Research and Chief Economist David Folkerts-Landau penned a hard-hitting Financial Times op-ed on the Italian situation, whose argument is that Europe must cut a grand bargain with Italy and that another costly sovereign debt crisis is inevitable unless the confrontational approach of the EC gives way to greater co-operation. According to Landau, Italy has actually been a frugal member of the single currency with a cumulative primary surplus every year outside of the GFC. However, these surpluses have simply helped finance the interest on the legacy debt and debt/GDP has still climbed. Meanwhile, the associated spending cuts and austerity required to run a primary surplus have lowered the standard of living for the population and led us to the political situation we find ourselves at today. What is his proposal?

The only viable option left is to reduce Italy’s debt service payments. This would create room to increase spending to modernise its economy without increasing the deficit and debt. Increased expenditure on infrastructure, and on ensuring that reforms are implemented, will ultimately boost the country’s growth rates from their current anaemic levels. This will also enhance its ability to service debt in the future. Should the economy not grow, then it is inevitable that we will be forced to accept a substantial writedown on Italian debt.

Effectively, what the German economist argues is that a grand bargain would see ESM firepower helping to substantially lower Italy’s funding costs, allowing for more public expenditure (e.g. infrastructure) in return for Italy undergoing structural reforms. Whether or not that happens is debatable. For now, it is safe to say that Italy and Brussels are very far away from the grand bargain that Folkerts-Landau thinks will eventually be needed.

Meanwhile, Italian 10Y bonds are just slightly wider, trading at 3.472%, up 0.034%... 

... as limited contagion allows the European Commission to keep a tough stance on Italy even as the latest Italian polls shows electorate support for the government is historically high, which will further encourage a confrontational deficit path. Eventually, the friction focus may be overtaken by deflating euro-area macro expectations and increasing Italian recession risks with the 400bps pain threshold suggested by Tria presenting a possible market target to force the coalition’s hand.

Separately, as Bloomberg's Mark Cudmore writes this morning in a note discussing why BTP bulls "bolster the Bearish Euro case", two common Italy-related views that are greatly troubling:

• being optimistic about the situation only because there's so much at stake. That's the head in the sand approach and suggests investors are relying on blind hope to get them through the other side, rather than analyzing the facts. It may work, but it's hardly encouraging!
• Many of those who are bullish BTPs medium-term seem to be using the logic that the market will drive yields up enough in the short-term that Italy and the EU will be forced to compromise. Entirely logical, but given the minimal concessions so far, it suggests BTP yields will need to surge significantly higher first, which would suggest that there's a very tradeable bearish move to focus on first before turning bullish.

Echoing the prevailing sentiment, which expects a continued impasse, Cudmore writes that "no one expects a major swerve from either side soon, which means it's going to be bad for both parties." Meanwhile, BTPs are expensive to short and volatile so not the obvious risk-reward play, as a result, he believes that it is the euro that will "continue to suffer over the medium-term, and you get the added kicker that any compromise that includes easier ECB policy than anticipated will also hurt the euro."

In any event, beware headline bombs over the next few hours as we approach peak posturing from both sides ahead of tonight's deadline.