When Italy Sneezes: Highly Contagious

Mid Week Bond Update

When Italy Sneezes: Highly Contagious

Italian politics, a sideshow earlier in 2018, jumped into the center ring over the weekend...


...as Italian President Sergio Mattarella declined to approve the heavily Eurosceptic cabinet proposed by coalition-designated Prime Minister Giuseppe Conte.

President Mattarella’s decision suggested that the coalition’s opposition to the European Union should be taken seriously – enough to disqualify them from governing the country.

Perhaps it was that assessment that spooked European bond markets to a degree not seen in years, driving gross yields on Italy’s 2-year sovereign debt as high as 2.826% on May 29,1 from a low of negative -0.331% on May 4.


Italy 2-Year Government Bonds: Monthly Gross Yields, May 2008 - May 2018

Source: Bloomberg, May 29, 2018 Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

Explanations vary about the reasons behind the intensity of financial markets’ reaction, given that the proposed cabinet’s positions were known well in advance. But one plausible narrative about the severity of the response has to do with the European Central Bank (ECB)’s long-expected move away from its current quantitative easing program.

If Italy’s finances are indeed fragile, the ECB could be stuck buying bonds for years to come to support the euro and the European economy. In addition, the size of any potential bailout (or bail-in) of Italy could dwarf the very expensive multi-year bailout of Greece, given that Italy has one of Europe’s largest economies.

One certainty remains: the ability of Italy’s politics to generate surprising outcomes.

 

On the Rise: The U.S. Dollar (again)

The impact on currencies of the week’s political challenges in Italy was clear; the US dollar rose some 66 basis points on a trade-weighted basis between May 24 and May 30. Reflecting the euro’s weakness, the pound fetched €1.1490, up from €1.1370 on May 28th – suggesting the euro’s travails were more alarming than Brexit – at least for a few days.

 

On the Slide: U.S. Yields, Bigly

The sharp fall in U.S. Treasury yields, from the 2-year all the way out to the 30-year, lent credence to the theory that Treasuries had become the beneficiaries of a global flight to safety. News that the recent auction of 2-year notes had met unexpectedly strong demand also supported the idea. In fact, the strong demand benefited the Treasury Department at the expense of buyers, who might have been hoping for higher yield from more heavily discounted securities.


U.S. 10-Year Treasuries: Daily change of yields, 5/29/15 - 5/29/18

Source: Bloomberg, May 29, 2018 Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.


The yields themselves didn’t tell the whole story, however; the drama was in the daily change in yields.  The -15 basis-point fall in the yield of the 10-year on May 29 was the largest single-day fall in yields since June 24, 2016, as the surprise results of the Brexit referendum rippled through global markets.

Another way to measure the upset: only eight trading days ago, on May 18th, the 10-year traded at 3.1261%; on May 29th, the yield was seen to trade, at least for a few minutes, at 2.7576%, a whopping 36.8 basis-point move in just under two calendar weeks.

 


1 All data Source: Bloomberg on their respective dates

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