George Soros' Bet On Italian Bonds

Includes: ITLT, ITLY
by: Investment Capitalist

In a classic George Soros moment, the legendary investor snapped his whip loud and hard against those running his massive hedge fund. Although this has been a common theme since the moment George Soros withdrew from day to day management, it’s my first time seeing him do it in a public forum, as guest of a YouTube financial show, “Freeland File”.

Asked about his recent $2 billion purchase of Italian 10 Year Bonds from MF Global (OTC:MFGLQ), he stated in no uncertain terms that if he were managing the portfolio, he would have a “much larger position in Italian Bonds”. Ouch. He may as well have gone on CNN and said “I don’t think my head manager understands risk”. He was actually asked if his managers first consulted with him prior to putting the position on. His response was classic Soros; “I haven’t been involved in managing the fund for a very long time now but if I was, I would have a much larger position in Italian bonds”.

Further explaining that around 6% to 8% the bonds are offering a fantastic speculative return, but at around 3% to 4%, the funds are too risky. Now if you’ve never read Alchemy of Finance, you wouldn’t catch the point. He’s explaining how irrational markets behave as indicated by the fact that Italian bond markets are “broken”. He also hedged himself by saying “it’s also a very dangerous trade”. Ok, so it’s both “fantastic and very dangerous”. Now that’s a paradox, which is precisely how Soros describes financial markets in the book.

The risk is rates blow out to 10% or something, causing a substantial loss on the position (obviously he’s using leverage). The only way that would happen however, is if Italy was allowed to default on its sovereign debt; something Soros said would “destroy Europe”. Moreover, it’s a risk-less trade for Italian Banks because they’re directly correlated with the fate of Italy, as Soros pointed out in order to show the existence of a large natural bid in the market. In other words, “if Italy was allowed to go broke, the banks would also be broke”. They would never allow Italy to default, as indicated by Europe’s push to stop any financial crisis in Greece. By saving Greece, it’s logical to assume Italy would also be protected.

But that begs the question: What if the ECB decided to let Greece default, thereby triggering defaults in other poorly managed countries attached to the euro? In such a case, the euro would shrink to a handful of countries with strong, fundamentally sound economies, while the rest returned to their former state currency. Some might say this would be advantageous for the remaining euro members as their countries would experience a flash export of inflation and the correlated surge in imports from the non-euro countries. In other words, supply side economics is once again working to fix the problem in weaker nations. Tourism would be hit pretty hard, and German exports would also take a beating because of a stronger euro. In the case of the latter, Germany is one of the world’s largest exporters. This is why Angela Merkel is keeping a poker face in the fight to stave off a Greek default. By leaning on the potential positives of letting Greece fail and insisting the market would function properly and keep the euro from rising too much, she is reducing her country’s potential exposure.

ECB rates are at historical lows, so there’s a tremendous amount of room for rate hikes. Furthermore, if the ECB is considering inflationary risks and a pre-emptive hike in rates sometime this year, those countries whose economies are already in bad shape would simply suffocate. This is why England dropped out of the EMU (predecessor to the euro). According to Keynesian economics, governments must be disciplined enough to swing into temporary deficits when their economy slows. To do so, they must reduce rates to an appropriate level. But if you’re tied to a basket of economies whose mandate it is to enforce a “band” which rates must stay within, and rates in your country are already at the lower range of the band, even trading below it on the institutional market, the only possible option is to drop out of the monetary union to prevent a run on the currency.

This was precisely the scenario when Soros made a billion dollars overnight betting against the Pound because he knew England had no choice but to withdraw from the EMU. And he knew this because he had already tested his theory on Italy prior to England’s withdrawal. Italy also withdrew from the EMU at the time in order to deflate the lira. Never one to manage debts properly, Italy is on a collision course with the ECB again. Could Italy be thinking they want the same flexibility as the Bank of England? Or is the thought completely preposterous as George Soros is suggesting? If I had to speculate, I’d bet on Soros. We’re dollar denominated anyway and it’s a good trade, since I don’t see the U.S. dollar rallying significantly this year.

The Federal Reserve never raises rates during an election year. In fact, the Fed tries to stay dormant until after the elections, but still has quantitative easing if needed by buying government debt. This is why I feel the U.S. dollar isn’t going anywhere this year. So Soros’ bet on Italian 10 year bonds seems like a high probability trade with the potential for massive gains because of the leverage involved. First, the 6% yield provides for a cushion in case the euro falls and rates headed higher. If rates head lower to be more in-line with their theoretical value, or as Soros put it, “the market fixes itself”, the trade would return around $500 million on a $2 billion bet; which probably has a notional value of around $18 to $22 billion depending on the leverage ratio. We’ll pay attention to this trade throughout the year. Since we can’t trade it, we’ll at least live vicariously through Soros.