Goldman Closes Italian 10-Year Bond Long Recommendation

Tyler Durden's picture

Trust Goldman to have keen, cutting-edge advice after the fact. Like now, a day after the collapse of the Italian government, when in a note, Goldman's Francesco Garzarelli who had been quite bullish on Italy, both in absolute and relative terms, flip-flops, and is now saying to no longer buy (i.e., sell) Italian bonds. To wit: 'The resignation of the PdL ministers will clearly increase volatility in the government bond market, similar to what happened between February and April, before the current government was formed. The spread between 10-year BTPs and German Bunds closed at around 260bp on Friday. At the end of April, we recommended going long Italian 10-yr BTPs against their French counterparts at spread of 221bp. We would be looking to close this position at Monday's levels."

From Goldman: Italy - Heightened Political Risk Weighs on Domestic Assets

Political instability in Italy has risen to a new level. All four ministers belonging to the centre-right PdL party in the coalition government of Prime Minister Enrico Letta have announced their resignations yesterday. Their immediate decision was motivated by disagreement over how to avoid, through the introduction of alternative measures, an automatic 1% increase in VAT this October designed to safeguard the deficit target. The backdrop to this unexpected twist of events is a rapid deterioration of the political climate after former PM Berlusconi was convicted of tax evasion by a High Court. As a result, Mr. Berlusconi will have to serve house arrest and no longer be able to run for public office (a Milan court still has to decide for how long). In the meantime, the Senate is due to vote on whether to remove him from Parliament, de facto putting him outside active political life. The Ministers' decision to pull out of Italy's cabinet came at the request of Mr Berlusconi himself.

The political turmoil comes at an unfortunate time for Italy, as next year's budget law is under negotiation and 'draft budgetary plans' under the new Two Pack legislation need to be presented to European partners by mid-October. To be sure, Italy's structural fiscal balance is relatively stable, better than in its peripheral peers and, arguably, France's. Italy came out on excessive deficit procedure in the Spring of this year, and its slippage from the 3% threshold is likely to be small (an official public finance update points to an overshoot of a few decimal places - hardly the case for significant market apprehension). But with a very high level of public debt (estimated to be just above 130% of GDP this year) and the highest rate of unemployment since the 1993 recession, the lack of progress in structural and institutional reforms due to a political paralysis may damage an already low level of market confidence and hold back the economic recovery further.

As is often the case in Italy, the near-term political outlook is highly convoluted. Moderate members of PdL have already expressed public dissent of Mr Berlusconi's hard line views, and may be exploring alternative alliances with centrist forces. Prime Minister Letta will ask for a vote of confidence in Parliament this coming week (media reports say on Wednesday, but no date has been formalized) to see whether there is an alternative majority supporting a reshuffled Cabinet. If there isn't, President Napolitano may decide to appoint a caretaker government that would be in charge of passing the 2014 Budget and possibly modify the current electoral law, which many observers say could increase the odds of another 'hung' Parliament.

Since the formation of Mr Letta's coalition government, our baseline case has been that fresh general elections would not take place in 2013 before the end of 2013, as many at the time had feared, but rather in the Spring of 2014. The 45 days from when Parliament is dissolved that is required before a ballot can take place means that an electoral campaign held now would clash with the budgetary session, and put the vote too far into the Winter. President Napolitano, who makes the decision on this matter, has already stated he will explore alternative solutions with political forces. From what we understand, this is increasingly the consensus view.

The resignation of the PdL ministers will clearly increase volatility in the government bond market, similar to what happened between February and April, before the current government was formed. The spread between 10-year BTPs and German Bunds closed at around 260bp on Friday. Some further widening could be justified in response to uncertainty on the composition of the new government, and whether its parliamentary support will come at the expense of the few reforms that Mr Letta's coalition was trying to see through. At the end of April, we recommended going long Italian 10-yr BTPs against their French counterparts at spread of 221bp. We would be looking to close this position at Monday's levels.

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Admittedly, the downside risks to our view of a contained negative impact from political instability have increased. A prolonged institutional crisis could decouple Italy from the recovery timidly visible in the rest of Europe. A downgrade of the sovereign (and domestic banks) to sub-investment grade would further undermine foreign demand. Related to this, on July 18, the ECB increased its haircuts on sovereign bonds falling in the BBB- to BBB+ category. Italy would already fall into this bracket, if it weren’t for the higher rating provided by the DBRS, the Canadian CRA. A credit rating downgrade by DBRS would expose Italy to a ‘jump’ into a higher haircut level (from a flat 5% to 5.5-8.5% depending on the maturity), raising the cost of funds for Italian banks at ECB's repo operations.