Monday, May 28, 2018

The Italian Job?

Joumanna Bercetche of CNBC reports, Traders are worried this could be the 'big unwinding' of Italian bond markets:
Italian bonds have witnessed one of their worst trading weeks since the euro zone sovereign debt crisis, with many traders getting a stark reminder of the volatility that once characterized markets in the region.

On Friday, two-year Italian bond yields rose 35 basis points in one day — almost equivalent to the entire range of the year for U.S. 10-year Treasurys. This was the weakest session in five years and continued a month that's seen these yields rise 70 basis points in total.

Yields move inversely to a bond's price and a spike higher is seen as investors feeling more concerned about lending to Italy's government. More specifically, traders usually sell short-maturity paper when there are growing credit risk concerns at a sovereign level.

The original catalyst for the selling came from the populist parties hoping to take control of Italy after inconclusive elections in March. Lega and the Five Star Movement (M5S) plan to issue short-term bills to finance state activity in their economic policy proposals. Market participants were taken aback and many have interpreted that initiative as laying the foundation for a potential parallel currency in the future, further amplifying the potential new government's collision course with the rest of Europe.

But the fear has not been limited to short-dated paper. Ten-year Italian bonds have also came under pressure with yields topping 2.5 percent and are now trading at their widest gap with German paper in over four years.

There is palpable anxiety in the market as Italy's political future remains uncertain. Over the weekend, M5S and Lega looked to have failed in their bid to form a government after President Sergio Mattarella rejected their pick for economy minister due to his euroskeptic credentials. This has raised the prospect of a caretaker government to lead the country into yet another round of elections later this year.

In Monday's trading session, and with liquidity in markets thin due to the U.S. Memorial Day, Italian two-year yields briefly snapped back 15 basis points tighter before paring all the gains of the day. Traders have pointed to short covering in the market.

However, the relief rally may be short lived. One head of trading at a large fund manager, who preferred to remain anonymous due to the sensitive nature of the situation, told CNBC that a "big unwinding" is beginning for Italian bonds and Monday's pullback would not last long.

Ratings agencies are also beginning to raise alarm bells. On Friday, Moody's hinted that it may look to review Italy's debt rating, citing concerns over the two anti-establishment parties' fiscal plans that could ratchet up spending by as much as 100 billion euros ($117 billion), according to some analysts.

With outstanding debt of more than 2.3 trillion euros and one of the highest levels of debt-to-gross domestic product in the advanced world, Italy's public finances will come under scrutiny again if spending ramps up.

Gene Frieda, a global strategist at Pimco, told CNBC via email that the immediate concern for investors is that another round of elections and the prospect of a right-wing anti-European populist government undermines the economic recovery in Italy.

"(It) threatens further rating downgrades. In that context, even after the recent sell-off, BTPs (Italian bonds) do not look particularly cheap," he said.

On Monday, Matteo Salvini, the leader of the right-wing Lega party, further added to market concerns saying that there is no point staying in the EU if the rules don't change. This has prompted some analysts to believe that if there is another election on the horizon, one that would effectively be a referendum on the euro.

According to Goldman Sachs analysis, the European Central Bank owns around 20 percent of outstanding Italian bonds due to years of quantitative easing, but foreign investors also own about 37 percent.

The question is then, will investors still want to own that risk into what could be a binary event?
Maybe the same hedge funds that ventured into Greek debt will buy Italian bonds as spreads blow up.

It's Memorial Day in the United States so markets are quiet on Monday.

But markets are open in Europe and things are going from bad to worse in Italy as bonds and stocks are crashing after an initial reversal.

Adding to angst, calls to impeach the president after a candidate was vetoed only poured gasoline on a popular uprising which views the Eurozone as anti-democratic.

Welcome to the European debt boomerang. Every few years, we are reminded of just how fragile things are in Euroland and why investing there is fraught with risks.

And as Zero Hedge pointed out this morning, contagion risks remain the biggest worry in the periphery:
While most investors are focused on Italian politics - the parallel currency 'mini-BoT' fears and potential for a constitutional crisis - Spain is now facing its own political crisis amid calls for a no-confidence vote against Rajoy. However, 'Spaxit' remains a distant concern for investors as another member of the PIIGS peripheral problems is starting to signal concerns about 'Portugone'?


As Statista's Brigitte van de Pas notes, on average, European Union countries had a gross government debt of roughly 81 percent of GDP in 2018.

This average disguises real differences between EU countries. Whereas Greece had a government debt of 177.8 percent in 2018, Estonia had a debt of only 8.8 percent - the lowest in the entire EU zone.

You will find more infographics at Statista

While the high Greek debt is well-known, a number of other countries however also have a debt that is higher than their own GDP. The Italian debt, for example, is lower than the Greek but still significant, at over 130 percent of GDP.

Portugal, in third place, had a debt of 122.5 percent.

One small positive note though: all three countries had even higher debts in 2017, and the European Commission forecasted a slow, but a further decrease of their government debt in 2019. Whether this holds true for Italy, with their newly-elected government of Movimento 5 Stelle and Lega remains to be seen.
And let's not forget Spain where Prime Minister Mariano Rajoy will face a vote of confidence in his leadership on Friday.

So, here we are, barely a week away from June and more drama is headed our way via the latest political and market blow-up in Italy.

I've long held the view that Grexit and even Brexit are a joke compared to Italexit.

Why? Because Italy's economy is much bigger than that of Greece's and if Italians hold a referendum to leave the Eurozone and actually vote in favor, it pretty much spells the end of the Eurozone and the euro.

I reckon tomorrow morning (and even today), global central banks are all on the phone with each other trying to play damage control.

No doubt, the ECB will continue backstopping Italian debt but other central banks including the Fed might intervene too.

So, hold on to your volatility hats because the summer has barely begun and we might be in for another European drama session.

All this trouble back in the ancestral home has really riled up CNBC's Rick Santelli. Below, he discusses the fragile banks and sovereign debt situation with Praxis Trading's Yra Harris.

All I can say is forget the wave of US coporate bond defaults headed our way, fresh troubles in Euroland are going to roil global financial markets unless central banks come to the rescue.

In this environment, stay long US long bonds (TLT) and the US dollar (UUP) and hope the Italian job won't clobber your portfolio.

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