Beware of Non-Linear Italian Risk

Includes: ITLT, ITLY
by: Erwan Mahe
Many of you have asked in recent days why we neutralized and reversed all our biases with our switch to risk off, since the decisions announced last Thursday by the European summit were for the most part welcomed.
In fact, I remain convinced that the measures adopted for aid recipient countries (Greece, Portugal, Ireland) are correct, since the longer maturities and lower interest rates granted will have a tremendously positive impact on their repayment prospects in time, while enabling them to carry out their needed structural reforms without brutally and unnecessarily depressing their growth outlook. The accent on direct investment may enable a surge in their long hoped for growth.
At the same time, the qualitative increase in the EFSF's power is welcome, be it in terms of the buybacks or off-program credit lines.
However, the lack of a quantitative increase in funds undermines the credibility of these measures, since investors are perfectly aware that, in the present situation, the resources allotted to the European facility are way too meager to contend with the threat represented by the next elephant in the room, namely Italy. Whether or not the funds will be sufficient for Spain is an open question, but I do not see how our Italian friends can avoid a catastrophic spiral, should Spain require help from the program.
Following improvement Thursday, the debt markets of these two countries are once again under strong pressure, as displayed in the graph below, with higher intra-day volatility and the constant evaporation of liquidity, which is another reason for anxiety considering the amounts involved.
Instead of providing one more interest rate spreads graph, I suggest you check out the yield curves on Bund and BTP futures contracts, as seen directly in real time on markets. The BTP future has become the new advanced risk on/risk off indicator, since the evaporation of the cash market.
Bund and BTP futures: Nothing works anymore!
Click to enlarge
The graph clearly displays the huge deterioration on the Italian debt market for the first 15 days of July, with the BTP shedding 10 whole points in six trading sessions, a true bond market crash.
The various announcements of meetings and those following the July 22 summit helped create a momentary short squeeze, thus taking the wind out of the flight to quality toward the Bund.
But following the realization by markets of the cruel lack of resources granted to the EFSF, Italian bond markets have once again plummeted while the Bund has firmed up considerably. It is interesting to note the opportune announcements on the FT's front page that Deutsche Bank (NYSE:DB) reduced its exposure to Italian debt by 88% in the first six months of 2011.
Aside from any serious macroeconomic study on the solvency of the debt of the Italian economy, suffering as it has been from anaemic growth and a huge debt-to-GDP ratio, market phenomena must now be the main focus of our attention.
In effect, the last 18 months have taught us that the debt of a distressed nation may quickly revert to non-linear behavior and enter a self-destructive spiral, leaving European leaders in the dust. After all, they have proven themselves unable to react in near enough time to breaking events on financial markets.
Imagine that our beloved credit rating agencies decide to downgrade ratings on Italian debt, which would hardly come as a surprise given their placement of it under negative watch in recent months (S&P, Moody’s) when it was trading at less than 4%. Today it is more like 5.20%.
As such, there is a risk that the credit rating agencies will react to these higher interests by downgrading Italian sovereign debt which, based on the same very classic cycle observed on earlier peripheral nation crises, whereby the downgrades led to forced bond sales by investors who must comply with the strict credit rating criteria on securities imposed by their portfolios.
In the context of a market in which buyers have disappeared, these forced sales will lead to lower Italian bond prices and thus increase the country's refinancing costs, resulting in the further weakening of the country's risk profile. In turn, this will lead to a new rating downgrade by credit rating agencies, leading to new forced sales, leading in turn to ...
That is what I call the non-linear aspect of the sovereign debt profile following a downgrade, and my hunch is that Italy is very close to being sucked into such a spiral.
So, in response to the questions raised by our clients, that is why Monday we advised clients to change their positioning to account for such a scenario by again favoring German debt, despite its high prices and the ECB's rigid posture.
We have also suggested the establishment of hedging strategies on risky assets, such as equities, on the basis of put spreads or ladders on stock market indices.
A new peripheral nation debt crisis, as Europe engages in a cycle of generalized austerity measures and the ECB remains obsessed by the fear of resurgent inflation(!), can only lead to serious damage to stock market valuations. And that's leaving aside the specific risk relating to financial shares, with their much more extensive exposure to Italian and Spanish debt than was the case for previous peripheral nation crises.
Well, there you have it. I admit the picture is anything but joyful, but it is not because I enjoy the work and humor of Lewis Carroll that I must deviate from a hard and fast realistic analysis.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: Long EDF 3 Y bonds, French and Italy long date 0 coupons, Greece 1 and 8 years bonds.