You know – some had been warning for a while that Italian government bonds were the true “too big to fail” instruments of the eurozone crisis, long before the bonds seriously began to trade like it.
People like Stefano Di Domizio, of Lombard Street Research.
For instance, Di Domizio was already arguing last year that the ECB would eventually be faced with — and might baulk at — intervention within the Italian bond market, because that market’s strengths (of liquidity, size, investor base) were being much too relied upon, and could quickly turn into a insoluble curse.
Well, we all know what’s happened since. So first of all, Di Domizio has come back with a striking graph showing the relationship between the yield spread, and recent bid-ask price spreads (the latter being a useful indicator of liquidity in the market). It makes the strength to weakness point very well:
Interesting, no? The point is, there have been similar problems in the market for Spanish debt, and Di Domizio notes that if anything, Spain would be much more vulnerable to the kind of slowing growth that it’s now being feared will tip Italy over. But Italy comes off worse because there are more bonds for the market to absorb and retain, at any point in time.
Here’s Di Domizio fleshing out that argument and also making one or two golden points about portfolio holdings of Italian bonds:
On our estimates, while net Italian bond supply is going to be virtually flat for the remainder of the year, having been about €45bn over the past four months, gross bond issuance still due this year is in the region of €80bn. Indeed, when bond markets liquidity dries up, gross supply is what matters. In an effort to reduce roll-over risk, the Italian Treasury could still increase the funding via syndicated deals and/or via off-the-run bonds. However, in the absence of a buyer of last resort, e.g. the ECB, restoring normal market depth will be difficult, keeping the BTP liquidity risk premium high, and preventing significant narrowing in the BTP/Bund yield spread.
Market volatility is one additional adverse factor for Italian bonds. Volatility on BTPs has doubled from a pre-crisis level of about 3bp/day to 6bp/day as measured since May last year. Hence, even assuming investors’ appetite for Italian bonds is not going to fade, notionals in BTP portfolios would have to be cut substantially in order to keep the same risk exposure. With volatility in BTPs likely to remain high over the foreseeable future, it is reasonable to expect investors would adjust their portfolios accordingly, leading to a structural deficit in BTPs demand. Along with hedge funds, at this stage non-Italian institutional investors are likely to be net sellers of Italian government debt. Even assuming Italian banks and life insurance companies stick with their current BTP holdings (together they hold about 30% of outstanding coupon bonds), selling pressure on BTPs is unlikely to fade anytime soon.
And if banks can’t even find liquid Italian bonds to collateralise interbank trades, what happens to that bit of demand, too?
Italy as the single point of failure – FT Alphaville
Battle of the BTPs and bonos – FT Alphaville
Tough auctions to prompt Eurozone peripheral funding rethink – IFR / Reuters