After a very volatile 2012 which presented plenty of opportunities for traders, many are asking themselves what will happen in 2013 in the Eurozone peripheral space.
First, let us review what the main events have been in 2012.
We started last year with Italy near a 100 bps disadvantage vs. Spain. Many people did not think this made any sense, particularly given the fundamentals of the two countries, and my personal idea of a fair value was for a 100 bps advantage for Italy. This happened to be the best trading idea of last year, together with the usual buy low, sell high. There were plenty of opportunities for traders, largely because of continuously high volatility in the Euro sovereign space, sustained by the uncertainty on possible exits from the Euro and subsequent significant haircuts in the value of sovereign bonds.
This level of opportunities will likely not materialize again in 2013. When ECB President Draghi pledged to do 'whatever it takes', adding that he stands ready to act to cap yields if a Eurozone country asks for assistance (and accepts conditionality), he essentially already capped yields without having to fire a single shot.
The mechanism is as follows: the market knows that the Spanish and Italian government have the option of asking for assistance. They also know that the likelihood of a request for help rises with higher yields, and seem to have concluded that if the yield rises too much there is a serious possibility of losing money. 'Never fight a central bank' has been the mantra of bond traders for decades: it still holds true today.
If we look at the volatility of Italian 10Y yields and of Italy-Germany spreads (chart below), we can clearly see a spike in the last 2 years.
Chart: Volatility of Italian 10Y BTP yield and of Italian 10Y BTP-German Bund spread
Thanks to, or because of, Mr. Draghi, this level of uncertainty, with the opportunities it carries, is unlikely to be repeated in 2013.
So what should traders do? First, it is entirely likely that a better world economy (although there are still risks) will make debt levels more bearable through increased economic activity and tax receipts. Also, the tide of austerity seems to have turned in Europe, whatever the still hawkish rhetoric in Berlin or Brussels. Austerity at a slower pace also is better news for growth. It is therefore entirely possible that peripheral spreads against German bonds will narrow more.
Looking at the situation with an eye to risk factors, one could think that in 2012 peripheral spreads were factoring in a significant level of credit risk. This risk has been lowered, possibly permanently, by the combination of the so-called Draghi put and the better growth prospects outlined above.
Therefore, those seeking opportunities in the Euro bond arena can either increase interest rate risk by increasing duration (it is difficult to argue against a higher probability of narrowing for the 10Y yield against those on the short line of the curve), or add other types of credit risks outside the Government space. There are still good opportunities on the corporate bond domiciled in peripheral countries. Many companies so far have paid a premium for the sole factor of their residence. Therefore a narrowing of sovereign spreads is bound to benefit those companies significantly. Watch, however, the big utilities, which seem to have already low enough yields.
With this, happy 2013 everyone. Trade carefully.