Credit Impulse Update: Italy
Investors are perhaps overly concerned by the upcoming presentation of the Italian budget, but a look at our credit impulse indicator shows that the country still faces very real economic risks.
Fixed Income Specialist
Italy's Five Star/Lega coalition government was certainly dreadful for investors, but by imposing a technocratic alternative, the president of the Italian republic might have played right into the populist parties' hands.
The sell-off witnessed following news that the Five Star/Lega coalition would not take power, with a technocrat government led by the pro-European Union Cottarelli established in its place until another round of elections, demonstrates that markets think things are poised to get worse even though the populist coalition didn't get its way.
The government proposed by the two parties last week was shaky and it was obvious that while its policies would have hurt the EU's third-largest economy, the coalition would have been short-lived due to the vast differences between the two parties. The blockade of this proposal, however, makes the Five Star/Lega coalition more dangerous.
It does not matter whether new elections will be held tomorrow, in three months or in a year: what is clear is that the longer it takes for new elections to take place, the more time the coalition will have to organise itself and return to the ballot booth stronger than ever.
At that point, they will be unstoppable.
The anti-austerity mandate that Italians have expressed at the beginning of March has not led anywhere, and euro-sceptic sentiment is strong within among Italian citizens. This could increase the risk of an 'Italexit' exponentially, which after Brexit would pose a death sentence to the EU as a whole.
In this highly volatile environment, however, opportunities will arise – but we have to be very careful to what risks we are willing to take on as we have learnt over the past few days that things can quickly turn sour.
Italian yield curve flattest since 2011 (two-year BTPS up 184bps to 2.70%): is this the dip?
Yesterday, the Italian yield curve flattened the most since the European debt crisis in 2011 as selling pressure was felt on the shortest part of the curve. The spread between the 10- and two-year BTPS reached 36.66 bps with the two-year at 2.70%, a huge spike considering that it closed at 0.868% just the day before.
Selling pressure was felt even though real money didn’t change its overall strategy towards the periphery which raises a valid point: how much can BTPs fall if real money investors start to move away from this space due to intensified periods of volatility and possible credit downgrades?
It is safe to assume that the spread of the 10-year BTPS versus the 10-year German bund can return to its 2011-2012 level near 500 bps as support from real money diminishes?
In the meantime, investors have to be ready to endure more volatility from Italian sovereigns. If a technocratic government led by Cottarelli proves impossible, new elections will be called as soon as possible, most probably leading to a populist victory.
If Cottarelli manages to form a new government we can expect volatility to stall during the summer months until the next elections are called.
However we look at the situation, nothing changes the fact that a yield of 2.7% for a G7 sovereign in EUR with two-year maturity is sexy, the only problem is: have we already touched the dip? The spread between two-year BTPs and bunds of the same maturity is 348 bps, the highest since mid-2012 when this spread reached 440 bps.
There is definitely space for more weakness, especially if Moody’s goes through with the downgrade mentioned in the past few days.
Portuguese government bonds are sliding with Italian sovereigns – should we worry?
Not surprisingly, the yield of other peripheral government bonds rose in sympathy with Italian BTPs; after Greece the biggest intraday loser was Portugal with yields moving up by 46bps before closing up 11bps. The sensitivity of Portuguese sovereigns probably comes down to the liquidity of Portuguese bonds; Portugal only has €221.4bn of bonds outstanding compared to €1.38 trillion for Spain and €2.78 trillion for Italy. This makes Portuguese sovereigns highly sensitive to volatility within the periphery.
The 10-year Portuguese government bond reached a record low yield of 1.60% in April, and now it is back at 2.16% – the same level seen in October of last year. Apart from negative sentiment in the periphery, investors have little to worry about from Portugal. The country has been able to implement reforms that have led it to a decrease in debt-to-GDP and it needs little funding for the rest of 2018. If Portuguese government bonds continue to slide they could became a real opportunity for investors who still want to ride volatility in the periphery but don’t want to be too exposed to its culprit.
High-yield space in second place
Since the beginning of May, spreads of high-yield EUR-denominated debt have been widening to levels previously seen in April 2017. According to the Bloomberg Barclays Pan-European high-yield (euro) average OAS index (LP020OAS), the average option-adjusted spread of high-yield corporates in Europe is 340 bps. Now that the spread between two-year BTPS and bunds is around 353 bps, it is fair to ask ourselves whether it makes sense to be invested in lower-rated, longer-maturity corporate debt.
The OAS spike in this space is obviously mainly led by losses incurred by high-yield Italian corporate names, but if the problems surrounding Italian euro-skeptic sentiment deepen, we can expect high-yield EUR corporates to suffer greatly and incur a stronger repricing.