In the aftermath of today’s political shock in Rome in which the populist coalition of the League and 5-Star launched an open rebellion against the president and Brussles, leaving the country facing a referendum on its Euro membership. and resulting in a furious crash in Italian bonds and bank stocks, which on Monday entered a bear market from their April highs…
… coupled with the sharp, sudden blowout in Bund-BTP spreads to levels suggestive of a news sovereign debt crisis in the Eurozone…
… and confirmed by the soaring redenomination risk not only in Italy, but also Portugal as contagion begins to spread…
… left only one question unanswered: why did it take the market so long to react to what many warned was coming as long ago as lat 2017?
After all, it was in December when we first pointed out a dramatic observation by Citi, which noted that over the past several years, the only buyer of Italian government bonds was the ECB, and that even the smallest political stress threatened a repeat of the 2011 “Berlusconi” scenario, when the freshly minted new ECB head Mario Draghi sent Italian yields soaring to prevent populist forces from seizing power in Italy.
Or maybe it didn’t, and it only took the bulls far longer than the bear to admit that nothing in Europe had been fixed, even as the bears were already rampaging insider Europe’s third largest economy.
Consider that according to the latest IHS Markit data, demand to borrow Italian government bonds — an indicator of of short selling — was up 33% to $33.3 billion worth of debt this year to Tuesday while demand to borrow bonds from other EU countries excluding Italy has risen only 5% this year.
That said, things certainly accelerated over the last week, when demand to borrow Italian bonds soared by $1.2 billion, which according to WSJ calculations, takes demand, i.e. short selling, close to its highest level since the financial crisis in 2008 (while demand to borrow bonds from EU countries excluding Italy has fallen by $800 million over the past week).
Said otherwise, while the events over the past week may have come as a surprise to many, to the growing crowd of Italian bond shorts today’s plunge and the blowout in Italian-German spreads was not only expected, but quite predictable and extremely lucrative… which is also a major problem as Brussels is well-known to take it very personally when a hedge fund profits from the ongoing collapse of Europe’s failing experiment in common everything, and tends to create huge short squeezes in the process, no matter how obvious the (doomed) final outcome is.
So who are these hedge funds who better watch their back?
According to the WSJ, the most prominent Italian short is also the least surprising:
Among big-name managers profiting from the selloff in Italian bonds is Alan Howard, the secretive billionaire co-founder of hedge fund firm Brevan Howard. A little-known hedge fund run personally by Mr. Howard has been betting that Italy’s borrowing costs will rise relative to Germany’s, said two people familiar with the fund’s positioning.
And considering the furious spike in the Italian-German spread, one can safe say that Howard is looking at a paper (for now) profit in the hundreds of millions if not more.
Profits from Mr. Howard’s position in Italy are among bets that have his helped the fund gain 7.5% this month and 13% this year, said one of the people. That makes it one of the top-performing funds to be betting on global bonds and currencies this year.
Another name making it rain as Italy goes down the drain is Robert Citrone’s Discovery Capital Management. According to the WSJ, Citrone, an alumnus of Julian Robertson’s U.S. hedge fund giant Tiger Management, “has also been betting on Italian bond spreads widening, said a person familiar with the matter.”
Of course, it is unclear just how long these funds’ winning ways will continue. As the WSJ accurately notes, betting against BTPs has been next to impossible in recent years, because despite the country’s 130% debt-to-GDP ratio and abysmal economic growth, the ECB’s relentless bond-buying has suppressed yields and made shorting the bonds extremely unprofitable.
Now, however, things are changing, and it is all due to the ECB (again, as we laid out in our December note): “traders say that has changed as the ECB slowly unwinds its stimulus package and political risk rises in Italy.”
“QE has destroyed any sense of risk in the sovereign bond market and we may be due for a very rude wake-up call once the dust settles,” said Joseph Oughourlian, founder of London-based hedge fund Amber Capital.
According to the WSJ, Amber has hedged its positions in Italian banks by betting that the spread between Italian and German government bonds will widen and shorting Italian corporate bonds, and for good reason: as BofA recently showed, in Italy there is “close to a staggering 90% of corporate credits” that now yield less than BTPs.
Yes, this means that according to the market, Italian corporate bonds are safer than the underlying sovereign, in this case Italy, itself, which is virtually impossible in reality, but is all too real thanks to the perverse action of the ECB which continues to buy Italian corporate bonds in the open market week after week, skewing the market beyond comprehension.
Meanwhile, Oughourlian and other shorters say the new government’s spending plans could push the country’s deficit up by €150 billion ($128 billion) while Rome could try to renegotiate its relationship with Europe; there is also the growing threat of a parallel currency which could effectively lead to a “fork” in the euro and the collapse of the common currency, something which Europe thought it had managed to prevent with the 3rd bailout of Greece in 2015.
“What’s most troubling is that markets haven’t yet woken up to this major political risk,” Oughourlian said.
And now that the period of denial is over, everyone else is starting to rush in:
“We’ve seen increased interest in owning volatility, particularly in European banks—not just Italy but other peripheral names,” said James Conway, EMEA head of equity trading strategy at Citigroup. “The theme [we’re seeing] is owning protection on the periphery.”
Needless to say, piling on into what is effectively a trade betting on the dissolution of the Eurozone right now is the worst possible outcome, and assures that it is only a matter of time before the ruthless despotic autocrats in Brussels change the rules once again, banning shorting of Italian bonds altogether, or even forcing shorts to immediately cover their positions, leading to another historic, if brief, short squeeze.
We now eagerly await to see just how long it will take the ECB and Europe’s unelected bureaucrats to put this specific plan into action, crushing countless hedge funds – who still believe in fair and efficient capital markets – in the process.