Despite today's relent in the panicked Italian bond liquidation which started several days ago and culminated yesterday with a record drop in 2Y Italian bonds, some analysts remain unconvinced that any bounce or relief rally will stick.
Unlike BBG's Mark Cudmore, who as we noted earlier, flipped from bearish to bullish on the hope that Italian bonds had sold off too far, too fast, BofA's Barnaby Martin writes that while for much of this year, he had pinned his bullish credit stance on a continuation of the very strong retail inflow story that was such a powerful support for the market in ‘17, flows have, of late, been elusive given the rise in global policy uncertainty and geopolitics, but nonetheless, "he had remained confident of their return given the record low level of rates vol in Europe, NIRP and rising household savings rates."
However, we think the political ructions in the European periphery over the last 72hrs will close the gate on this inflow narrative for a while now. After all, retail flows have shown a high level of sensitivity to Eurozone developments since 2011.
Therefore, to the BofA credit strategist it is the absence of inflows into Euro credit spreads that means they will likely stumble wider the foreseeable future: "Think of the “glue” of the market disappearing. Yes, relief rallies may well punctuate the gloom, simply given how violent and quick the move in Italian risk premiums has been."
There is another reason why Martin sees the staying power of rallies as very limited: think aggressive supply.
Any period of relative market calm over the weeks ahead will be met with a wall of new issuance as corporates bring forward refinancing plans, given the rise in uncertainty. But big new issue premiums will be the order of the day, and without inflows, this means secondary bonds will be re-priced wider. In fact, the market has struggled for most of this year with the new issue backdrop simply because of weaker inflows
The third, and arguably biggest risk, is the ECB: the central bank has "worked tirelessly" over the last few years to reduce fragmentation in the Eurozone. In fact Draghi - who himself ran the Bank of Italy before taking control of the ECB - has gone the extra mile to make this work favorably for Italy: according to BofA calculations, the cost of borrowing for Italian SMEs is now lower than it is for French SMEs. This however, is also a double edged sword as years of artificial central bank support mean the periphery is now put at even greater risk of re-pricing wider should the Italy saga dictate that the ECB stops QE sooner rather than later.
That is not to say that the ECB will be ending its market support any time soon, and according to Martin, "for as long as politically possible", the ECB has the “back” of the credit market. In fact, instead of tapering, Draghi has ramped up corporate bond buying recently to deal with the resurgence in political risks. And by owning less than 20% of all eligible paper, the ECB's corporate bond buying program, or CSPP, is far from running into scarcity problems at this stage.
This means today’s credit sell-off is a much “lower beta” version of that seen during the periphery crisis in 2011-2012, for instance. It has also left many Italian credits (corps and fins) better protected in the widening compared to BTPs. The new norm will be Italian credits trading tighter than Italian sovereigns, we think. But investors should still be wary of Italian credits that trade significantly tighter than BTPs, as history has shown that relative value re-pricing eventually plays out.
Indeed, as Martin showed last wee, close to 90% of all Italian credit trade inside of similar maturity Italian government, "a historical high by a long way."
Meanwhile, for those who would prefer not to sell during this or future selloffs, it is becoming increasingly expensive to hedge. As Martin notes, "credit vols have also re-priced higher, but are still below the levels seen last February during the equity vol shock."
However, it feels that tail-hedging has become increasingly more expensive (in vol terms) as the put/call implied vol skews have steepened disproportionally to the moves in spreads and vols. We think this shows the need for downside hedging in a market that was priced to perfection. With spreads at very tight levels, credit investors looked for the cheapest convex hedging instruments out there, lifting OTM puts to hedge for downside
So with those skeptical thoughts in mind, here are the 12 key charts that according to Martin matter the most for where Italy may be headed.
Fund flows into IG funds have been hit by the recent BTP sell-off
Credit is realized lower betas vs. rates in this move higher for BTP vs. Bund spread when compared to the pre-QE era
Credit vol and spreads broadly in-line vs history
Downside hedging interest elevated post the Feb vol sell-off
“Redenomination” risks in the Eurozone are starting to be priced-in by the credit market again
Thanks to the presence, and monetary tools, of the ECB, the sell-off in IG credit today is more mundane than history suggests
Sentix Euro Break-up Index jumped following the recent events
So much fragmentation risk had already been reduced
Italy got smaller in HY – but is still of major importance
Italian HY financials have already moved aggressively
Cumulative 3M flows in IG
Cumulative 3M flows in HY
In a subsequent post, we will step away from Italy's micro to look at what the troubled European nation's big picture macro, long-term charts say.