Arm Me With Carry, Conte Drop A Load On 'Em...BTP, How Can I Explain It?

With Italian debt markets feeling an awful lot like everyone's old friend Wile E. Coyote after a bad run in with The Market Formerly Known As The Roadrunner, the old saws are at it again: of course lending money at negative rates to Italy of all places was going to go poorly! Just like that century bond in Argentina was such a bad idea. 

Similar to the century bond claims, which have been given good treatment by others, including TMM's Shawn, context is absolutely necessary for the case of Italian debt spreads. First off, let's keep in mind that even with a serious rough patch in 2011 and the mother of all duration rallies in all things safe and EUR-denominated since, BTP futures have outeperformed bunds since inception. In the chart below, we show the relative performance of IK futures (~10y BTPs, currently IKM8) versus bund futures, since the inception of the IK futures. For the record, these two contracts' duration has always been within 5% of each other with a median of 36 bps difference since inception. So we don't need to worry much about adjusting for duration to get a like-for-like comparison of rate risk. We also have availed ourselves of Bloomberg's roll-adjustment feature to make sure that roll yield and CTD differences are all sorted out.

Now, granted, there have been some excellent directional trading opportunities for the spread. 2011 is a good example, as was the peripheral widening of 2016 when markets digested Brexit and the risk of French elections gearing up. But all-told, you've earned 5% simply owning BTPs and shorting bunds via futures. And that includes the most recent move.

Of course, that doesn't include the embedded leverage (roughly 29:1 on BTPs and 71:1 on bunds based on straight-up initial margins for both). But the key thing is, even with the huge drawdowns of the Eurzone crisis, BTPs have been a great bet for the past half decade by and large.

We can also take duration right out of it. Below we show the total returns over the last 10 years for two series: the market-value weighted Italian bill index (BoTs) and returns for constant-maturity EUR LIBOR. Again: outperformance.

Skeptics will, fairly or unfairly, note that the 8% spread over bunds for 12 month BoTs back in 2011 give one heck of a tailwind for returns here. They've probably got a point.

To mollify the starting point crowd, here's the same chart started on the last day of 2013, when spreads had sunk into their contemporary range. Again: outperformance!

The answer to the question "how could you lend to Italy at negative yields" is therefore pretty plain. It's because risk premiums could only get so high, and with negative "risk free" (always a purely academic concept, but here meaning "least risky") yields elsewhere, either spreads had to be ludicrously high or nominal yields had to head below zero. Financial markets are always and everywhere a relative game, and as much as we love heuristics like "nominal yields should be positive", sometimes they don't work and there's nothing we can do about it.

As it stands now, the move higher in BTP yields has been swift and frankly gnarly. But when combining the extra risk of term with the extra risk of credit over prevalent short-term "risk free" (scare quotes again) rates, BTPs now carry 2.5x the premium that bunds do, and at a lower duration and lower convexity.

With all of that said, the combination of rapid shock higher on pure expectation with relatively elevated risk premiums suggests to yours truly that things are primed for reversion. How the whole Italian curve trades is going to be very much dependent on how quickly Lega and the 5 Stars hear the screamed message of "y'all are out yo' damn minds" that markets are sending. With the ECB taking down 3.5bn EUR per month in Italian debt (and now holding as much as Italian banks do, give or take), a ~3% of GDP current account surplus, and broadly stable global credit markets with just-fine-thanks growth, Italy's self-inflicted mark-to-market wounds will heal quickly should the politicians decide to heed the message they're being sent. The question is, are Messrs Salvini, Di Maio, and Conte going to get the message? If not, will one of the two parties cry "uncle" and put a halt to the bold experiment in Italian populism, or at least enough to signal that Wile E put on the breaks in advance of the cliff? Given that nobody has even introduced any legislation yet, let alone sat down across from the people that drove Our Man Varoufakis into the pages of Paris Match, there's now room to eye the risk premiums in BTPs and BoTs more jealously. Now, play us off, will you Yanis? We know you're down with BTP.