% Points of Interest
Italy’s Awful Week = A Lesson for Investors
Market headlines last week were dominated by foreign affairs, as fresh political turmoil in Europe prompted large yield shifts in several major sovereign bond markets. These developments also serve as a fresh cautionary tale – with an Italian flair – for how suddenly a badly-mispriced security can generate real pain.
Italy, a country with a parliamentary system at the federal level, recently held national elections which did not result in any single party or alliance of parties winning a majority of the votes. When this happens (in formal terms, a ‘hung parliament’), there’s a scramble among different parties to be the first to form a coalition which can collectively total the necessary majority to govern.
While a hung parliament was the expected outcome, what came next was the surprise: two anti-establishment parties struck a coalition agreement and appeared to secure the mandate to govern Italy. While the anti-establishment coalition worked on hashing out who to pick for Prime Minister and other important cabinet posts, markets quickly focused on leaked details of the economic platform. Specifically, the coalition was considering several radical proposals, including:
- Reducing the large Italian debt load (app. 130% of GDP) by asking the European Central Bank (ECB) to unilaterally forgive the tens of billions in Italian sovereign bonds it owns as a result of years of quantitative easing purchases
- Simultaneously greatly reducing taxes while increasing government spending. This fiscal stimulus would come at the cost of greatly increasing the budget deficit (in direct contravention of European Union fiscal caps)
- Establishing what is effectively a parallel domestic-only currency alongside the Euro, which could legally be used to settle Italian debts and taxes. Unlike the centrally-controlled Euro, this domestic currency could be devalued by the Italian government at will, providing monetary stimulus.
These ideas plainly contradict core European Union rules and treaties, as well as the principles underlying the collective Euro currency. For the incoming government of a major European country and economy like Italy publicly consider them is truly remarkable, and is the reason why this story morphed from interesting curiosity to an international market-moving event.
The Market Reaction
Here’s where this becomes relevant. Markets swiftly reacted in a logical pattern:
- Most visibly, Italy was swiftly punished by seeing its sovereign bond yields rocket higher to account for their greater repayment risk;
- As a knock-on effect, the sovereign bond yields of other fiscally-fragile European countries (such as Greece, Portugal, and Spain) increased significantly as well;
- Large global investors reallocated some of the sale proceeds into safe-haven assets such as US Treasuries, spurring large yield decreases (recall that bond yields and prices move in opposite directions).
The most direct effect for US investors was the decline in US Treasury yields: over a 1 week period, 2 and 10 Year yields declined 0.25% and 0.28%, respectively. However, the truly lasting lesson is in the fate of Italian sovereign bond investors.
US Treasury Yields
Unlike the US, the overall European economy has not witnessed the same degree of post-crisis improvements in economic fundamentals. Although most Eurozone economies are struggling with lackluster expansions rather than outright recession, the European Central Bank has felt compelled to continue its massive post-crisis quantitative easing program in an attempt to stimulate faster growth. Recall that quantitative easing involves a central bank creating money to purchase large amounts of bonds, which artificially depresses yields.
Italian sovereign bonds also benefitted from this massive suppression of market-generated signals, despite the country’s long track record of political and financial dysfunction. Like other European countries’ bonds, many Italian sovereign bond maturities actually traded at or near negative yields for years, including its 2 Year bonds as recently as three weeks ago.
In the wake of this news, that situation changed in a hurry: over two weeks, the 2 Year Italian sovereign yield shot up from -0.08% to +2.70%.
Since then, while a portion of this move has been retraced (Italian 2 Year yields are down to 1.28% as of 6/6/2018), much of the damage has proved lasting.
2 Year Italian Sovereign Bond Yield
Source: Bloomberg (as of 5/29/18)
The situation is even more distressing when showing it in terms price change: during those same two weeks the yield rocketed up to 2.70%, the 2 Year bond’s price plummeted from $101.0 to $95.4.
2 Year Italian Sovereign Bond Price
Source: Bloomberg (as of 5/29/18)
Moreover, as often happens with large market moves, liquidity suffered at the same time. The normal bid-ask spread (the yield differential a dealer charges to buy a bond vs. sell the same bond) for a major sovereign issuer is typically only 0.02% or so. For the Italian 2 Year bond, that spread quickly ballooned to 0.13%. In other words, Italian debtholders already hurting from a big price decline took even more pain just to cut their losses.
2 Year Italian Sovereign Bond Bid-Ask Spread
Source: Bloomberg (as of 5/29/18)
Italy is neither a small nor insignificant country: a core member of the Eurozone, it is the world’s 9th largest economy and a powerhouse of heavy manufacturing. It is also one of the top 10 sovereign debtors in the world, with outstanding bonded debt totaling the equivalent of well over $2 trillion. In short, the Italian debt market is not some little-noticed backwater, which makes the speed and magnitude of these moves stunning.
But here’s the kicker: it is ridiculous to assume this is because Italian debt suddenly became much riskier over the preceding 2 weeks. Italian politics has long been chaotic and dysfunctional, and the anti-establishment coalition potentially coming to power has been a well-known prospect for some time. Likewise, Italy’s finances are perpetually precarious, which has resulted in longstanding market speculation that a Brexit-like rebellion against the European Union (a so-called “Italexit”) is a remote but legitimately possible scenario.
Simple logic dictates that the risk of these developments should have been built into Italian bond yields beforehand – greater risks should require greater potential reward. But it wasn’t – given the ECB’s blatant and well-known suppression of rates and volatility, Italian debtholders had recently been accepting negative yields! There was no reasonable argument that Italian fundamentals and future prospects justified such generous financing terms. This was clearly an egregious mispricing of risk that prudent investors could have avoided.
The key insight to be gained from this is one that Treasury Partners has consistently embraced in the post-crisis years – the prudent investor shouldn’t accept obviously mispriced risk under any circumstances. This is certainly not easy, as there are always rationalizations beforehand for breaking this rule. For example, two weeks ago there were several ways an Italian bondholder could have justified their position:
- “Almost all European short-term sovereign bond yields are negative, might as well pick the least-negative ones. What’s the worst that can happen?”
- “Italian bonds are some of the highest-yielding in the Eurozone, if we don’t hold them we may lag the returns on our benchmark. That, and not capital loss, is what we should worry about.”
- “The ECB has been artificially suppressing yields for years now. They control the situation, and won’t simply give up now and allow rates to shoot up. Italian yields will stay low regardless of fundamentals.”
Rationales such as these were just as ill-conceived then as they are now, and it’s important to realize that they can easily be applied to almost any mispriced market risk. Italian bondholders must now reflect on this lesson after saying arrivederci to a good chunk of their capital.
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