The next ‘big short’
26 June 2018
David Lewis of FIS suggests there may be another issue looming on the horizon that could have significant European, if not global, ramifications, triggering a tidal wave of economic change across the Eurozone
Image: Shutterstock
For those of you that watched the instructive and insightful film, ‘The Big Short’, you will know that the basis of the story was the structural issues with the value of certain debt products. They were a nightmare hiding in plain sight, denied as an issue until it was too late. While not quite the same, there may be another issue looming on the horizon that could have significant European ramifications, if not global, as it could trigger a tidal wave of economic change across the Eurozone, and little of it good.
On the positive side, it may divert attention from the constant chatter about Brexit and the effects that change will bring. ‘Quitaly’ may become the new subject du jour of dinner tables, banks and media economists, exploring the potential impact, including the winners and losers of the fallout should Italy leave the Euro or even the EU. There are, of course, a multitude of factors here, and not all of them based on economics. Few could have missed the recent issues with Italy refusing entry to three ships of immigrants rescued from the waters of the Mediterranean, arguably on a technicality of due process, but perhaps more importantly, a sign that certain parts of Italy are reaching the end of their capacity to accept migrants. Even Germany is embroiled in internal arguments about limiting migration, having accepted perhaps more than any other country in Europe. This, in turn, has brought it into direct conflict with the leadership in the US. The new coalition in Italy, borne of the right wing League party and the difficult-to-describe/pigeonhole five-star movement, has, by the omission of a clear strategy, allowed a space to form into which doubt, fear and speculation has flooded. Remarks regarding the plan to exit the Euro, and even to default on debt to the EU, has sent markets spiraling and the yield on Italian government debt to soar. To add an extra layer of glamour and intrigue, allegations have even been made regarding some Machiavellian plot to destabilise the Italian markets in order to benefit those holding short positions. The hedge fund, Brevan Howard, was specifically mentioned in an article in Corriere della Sera, the Milanese establishment newspaper. A robust response from the fund followed with a hasty revision and an apology was quickly published, but the damage was done.
The yield differential between German and Italian 10-year government bonds jumped from 130 basis points before the article, to 320 basis points after it was published. Brevan Howard made no secret of its bearish view on Italian assets and gained some 37 percent in May, but it was not alone. Public disclosures name eight other large firms, including household names such as Marshall Wace and Lansdowne Partners.
Looking to the financing data around Italian government debt, the 12 months to May showed a remarkably stable environment. The European Central Bank (ECB) has done much to try and balance Eurozone debt, pumping liquidity into the market over an extended period, offset, at least in part, by its own asset lending programme, and this had become the new normal for the market. A recent announcement from the ECB has suggested that the asset purchase programme will begin to scale back in the not-too-distant future, but this appeared to have little effect on the markets compared with the prospect of ‘Quitaly’.
Figure one shows the indexed value of German government debt borrowed versus that of Italy. The quantities of debt in real terms are between 10 and 15 to one, German to Italian, so indexing gives the comparison of the overall trend more clarity. As the graph shows, the value of Italian bonds borrowed has risen dramatically, especially if it were adjusted for the collapsing asset prices, implying a much faster growth in quantity.
Figure two shows the intrinsic cost of borrowing German and Italian debt, again indexed for clarity and comparison. Two elements stand out in this graph, the first being at year end last year, when the clamor for high-quality liquid assets pushed the cost to borrow German debt sky high. Notably, the cost to borrow Italian bonds did not flicker, arguably indicating a market distaste for the assets at that time, and, to some extent, providing evidence that borrowing of these assets, when it does occur, is more likely to be for shorting than for balance sheet operations.
The second is the leap in borrowing costs for Italian debt in May and June, reflecting the increased demand from those looking to short the bonds in anticipation of their prices falling and yields soaring. Is this evidence of some plot to undermine the credibility of the new Italian coalition to make profits in the short term? While the statistics could be used to suggest such a plot, and as mentioned above, some did just that, the coalition members have made little secret of their dislike to the Euro and, in some quarters, dissatisfaction with the EU itself. This is enough to damage confidence in the markets without the need for underhand tactics. The normal economic reaction in such situations, whether personal or governmental, is that the less attractive borrowers will need to pay more to raise capital. While the spread between German and Italian 10-year bonds has narrowed a little following calming words from Italy’s economy minister, the doubts about the plans from the coalition remain, and those holding short positions continue to gain from the uncertainty about where this issue goes next.
While the rise in borrowing activity around Italian debt could well be attributed to those large funds taking positions, there is much less evidence of some nefarious plot; the issues in Italian politics and the structural weaknesses in its economy are there in plain sight, just as they were with collateralised debt obligations in The Big Short.
It may just take a while for others to see the issues for what they really are.
Figure one: German and Italian Government debt on loan, indexed to March 2017
Source: FIS Astec Analytics
Figure two: Cost to borrow German and Italian Government debt, indexed to March 2017
Source: FIS Astec Analytics
On the positive side, it may divert attention from the constant chatter about Brexit and the effects that change will bring. ‘Quitaly’ may become the new subject du jour of dinner tables, banks and media economists, exploring the potential impact, including the winners and losers of the fallout should Italy leave the Euro or even the EU. There are, of course, a multitude of factors here, and not all of them based on economics. Few could have missed the recent issues with Italy refusing entry to three ships of immigrants rescued from the waters of the Mediterranean, arguably on a technicality of due process, but perhaps more importantly, a sign that certain parts of Italy are reaching the end of their capacity to accept migrants. Even Germany is embroiled in internal arguments about limiting migration, having accepted perhaps more than any other country in Europe. This, in turn, has brought it into direct conflict with the leadership in the US. The new coalition in Italy, borne of the right wing League party and the difficult-to-describe/pigeonhole five-star movement, has, by the omission of a clear strategy, allowed a space to form into which doubt, fear and speculation has flooded. Remarks regarding the plan to exit the Euro, and even to default on debt to the EU, has sent markets spiraling and the yield on Italian government debt to soar. To add an extra layer of glamour and intrigue, allegations have even been made regarding some Machiavellian plot to destabilise the Italian markets in order to benefit those holding short positions. The hedge fund, Brevan Howard, was specifically mentioned in an article in Corriere della Sera, the Milanese establishment newspaper. A robust response from the fund followed with a hasty revision and an apology was quickly published, but the damage was done.
The yield differential between German and Italian 10-year government bonds jumped from 130 basis points before the article, to 320 basis points after it was published. Brevan Howard made no secret of its bearish view on Italian assets and gained some 37 percent in May, but it was not alone. Public disclosures name eight other large firms, including household names such as Marshall Wace and Lansdowne Partners.
Looking to the financing data around Italian government debt, the 12 months to May showed a remarkably stable environment. The European Central Bank (ECB) has done much to try and balance Eurozone debt, pumping liquidity into the market over an extended period, offset, at least in part, by its own asset lending programme, and this had become the new normal for the market. A recent announcement from the ECB has suggested that the asset purchase programme will begin to scale back in the not-too-distant future, but this appeared to have little effect on the markets compared with the prospect of ‘Quitaly’.
Figure one shows the indexed value of German government debt borrowed versus that of Italy. The quantities of debt in real terms are between 10 and 15 to one, German to Italian, so indexing gives the comparison of the overall trend more clarity. As the graph shows, the value of Italian bonds borrowed has risen dramatically, especially if it were adjusted for the collapsing asset prices, implying a much faster growth in quantity.
Figure two shows the intrinsic cost of borrowing German and Italian debt, again indexed for clarity and comparison. Two elements stand out in this graph, the first being at year end last year, when the clamor for high-quality liquid assets pushed the cost to borrow German debt sky high. Notably, the cost to borrow Italian bonds did not flicker, arguably indicating a market distaste for the assets at that time, and, to some extent, providing evidence that borrowing of these assets, when it does occur, is more likely to be for shorting than for balance sheet operations.
The second is the leap in borrowing costs for Italian debt in May and June, reflecting the increased demand from those looking to short the bonds in anticipation of their prices falling and yields soaring. Is this evidence of some plot to undermine the credibility of the new Italian coalition to make profits in the short term? While the statistics could be used to suggest such a plot, and as mentioned above, some did just that, the coalition members have made little secret of their dislike to the Euro and, in some quarters, dissatisfaction with the EU itself. This is enough to damage confidence in the markets without the need for underhand tactics. The normal economic reaction in such situations, whether personal or governmental, is that the less attractive borrowers will need to pay more to raise capital. While the spread between German and Italian 10-year bonds has narrowed a little following calming words from Italy’s economy minister, the doubts about the plans from the coalition remain, and those holding short positions continue to gain from the uncertainty about where this issue goes next.
While the rise in borrowing activity around Italian debt could well be attributed to those large funds taking positions, there is much less evidence of some nefarious plot; the issues in Italian politics and the structural weaknesses in its economy are there in plain sight, just as they were with collateralised debt obligations in The Big Short.
It may just take a while for others to see the issues for what they really are.
Figure one: German and Italian Government debt on loan, indexed to March 2017
Source: FIS Astec Analytics
Figure two: Cost to borrow German and Italian Government debt, indexed to March 2017
Source: FIS Astec Analytics
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