Wednesday, 30 May 2018

BTP time bombs.

My last post was on Turkey and oil. Oil, only briefly to say it was turning and Turkey in a great long verbose way to say it was turning.

Last week every eye was upon the Turkish lira. But market attention is drawn not by absolute badness but by relative baldness, so the complete explosion in Italian politics over the last five days has drawn the macro tourists away from Turkey, leaving it free to pick itself up, dust itself down and become one of the world's best performing assets this week, knocking the socks off even the USA. Oil has also continued its downwards track leaving the long Turkey short oil trade looking like a podium winner. But there is no one even watching the champagne spraying ceremony because they have all dashed off to Italy.

Italy is really big stuff compared to the shakedown of a Turkish market that has already been seriously shaken down. If you think Turkey is a source of contagion in EM, you just have to watch what Italy can do to the DMs.

Italy is where risk and reward have been forced together between the huge clamps of ECB policy. Applying billions of Euros of force to the BTP market the ECB has managed to hold things for long enough to convince the market that Italian risk was not far off German risk and that Italian yields could be lower than US yields. And the money poured in on the implicit promise that the ECB would always be there and the explicit promise that they ‘would do whatever it takes'. Which is all fine as long as Italy doesn't decide to tear up its agreement with Europe and hence the ECB.

Unlike Turkey, Italy has a LOT of money parked in its debt markets. First, because it has a lot of debt and second because it pays more than the rest of core European. Finally, it will only lose you money if it defaults.

Losing money in bonds is a game of peek-a-boo. If you don't look at it won’t have cost you anything because any bond with a positive yield will, on full repayment at maturity, have made you money on an absolute basis. However, on a relative basis, things can be very different. Bond markets are about chasing the best yield and that implies relativity. Bond performances are barely ever measured against absolute return, instead choosing to be measured against a benchmark. So relative performance is absolutely key for measuring success. As soon as we have the relative performance we have to keep a track on how things are going and though we know we will get our money back in the end, if the value of bonds fall relative to the benchmark we are 'losing money’.

One obvious way not to be losing money, if we know we’ll always make in the end, is not to look at the price of the bond whilst holding it. 'No looky' no lossy'. Or no mark to market. This is what the ECB does with its holdings and that applies to the current 250bio it has on its books through QE. If it has no intention of selling them before maturity then there is theoretically no reason to mark them to market.

Funds are a different kettle of fish as investors constantly want to know what the worth of their assets are for value and for risk management sakes and that involves measuring them against current market prices. Kaboom.

Italy has always been a dirty little secret in real money portfolios. The long-term traditional real money accounts have huge amounts of higher (well, it was) grade Italian debt on their books under the title of European bonds. Desperation for yield and performance has forced many to wade into the 'Draghi guaranteed' higher yielder. There was little chance of being criticised by senior management for being long Italy, as to doubt Draghi was to doubt the existence of the Euro and therefore the existence of your own large European financial institution. If you know the event that blows up your fund also blows up the whole company then there is no relative disadvantage to holding them, if it blows up you lose your job either way.

When Europe started to recover and the Eurozone lift-off story started propagating 18 months ago, the chance of Italian default through local credit pressures was seen to fade and the demand from private hands to buy the previously considered toxic NPLs and sub-grade debt that was polluting Italian banks’ balance sheets was huge. The banks eagerly offloaded swathes of it and were starting to be classed as clean again. So banks were bought again too.

The purchasing of Italian based debt by private hands has been huge. Real money, hedge funds and SWFs own it and swathes of it have been built into all sorts of illiquid high-yielding structured products. The Italian banks are still holding enough of it together with government debt, to have some serious problems. Everyone is up to their necks in it.

The question is who has the longest mark-to-market interval. If you don’t have to look at the relative value then you might be able to ride this out as long as there is no default or restructuring into NuevoLira. But trying to keep a lid on exposures is going to become harder as time goes on. We are going to see fissures open up in places we probably haven’t yet imagined. Try picturing financial Europe as a Hawaii Big Island lava map. Even Herr Oettinger may find the soles of his feet warming up through German institutions' Italian debt holdings.

BTPs erupt in Portfolios

So in summary. I am a fader of peak 'tabloid' noise. Tabloid noise is indeed at a fever pitch. But in the case of Italy, we are not quite there yet. Mrs Watanabe has not yet sung and, though trying their best not to make any noise, those with Italian debt embedded in ‘safe' funds are going to be crying for their mamas before we see this over. Of course, that is unless Mr Draghi and the Eurocrats bow to quiet pressure to ‘just sort it out’.

I had wondered whether Italy might issue 250 billion of a 1000yr zero coupon BTP. They could exchange this with the ECB for all the shorter-dated stuff they hold and as ECB isn't mark-to-market, they would have effectively written off Italy’s debt. Just an idea.

Finally, its time to resurrect a post from 2014 which is once again very apt. Though my interpretation this time is that there is a lot more to worry about.

Monty Python's Four Italians sketch

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