AXA IM | The Italian Referendum on constitutional reform in early December threatens further instability. The Italian Prime Minister Matteo Renzi has threatened to resign if the vote on the reform of the constitution does not go his way, which has been worrying markets. The fact that he is now seen as unlikely to follow this through is seen as some comfort if he doesn’t win, but arguably the real risk is that he wins rather than that he loses. On current polls and trends, a reform of the upper house (which is what is being proposed) could deliver power to the M5S party, who have promised a Referendum on Italy’s membership of the euro. This would threaten a re-run of the 2011/12 euro crisis since the problem would be the same as back then; how do you hedge an unhedgable currency risk? Owners of Italian bonds (and the perception would be of other peripheral countries as well) would risk being paid back in a depreciating currency. Not surprisingly money then flows out of the periphery back to the core countries, placing strain on the balance sheets of peripheral country banks. Strain that is offset by offsetting transfers via the ECB. We can monitor this via the fact that the ECB publishes data on theses flows, known as TARGET balances, standing for Trans-European Automated Real-time Gross Settlement Express Transfer system. Chart 1 illustrates the trends in Italian and German transfers.
We can see that while the positive flows on Germany are not quite as high, the negative balances in Italy are now greater than they were at the peak of the euro crisis in 2012. Either or both of these factors, tighter liquidity thanks to repatriated cash balances or renewed concern about the stability of the euro could cause problems for European banks. These have rallied over the last month, presumably on the back of rising bond yields (see below) but would need to be watched carefully. Perhaps reflecting this the yield on Italian 10 year bonds has risen more rapidly than that for German bonds in the last few weeks, as shown in Chart 2. While German yields are still a little over 20% lower than this time last year, Italian bond yields are now higher.
In effect the spread between the two has widened noticeably in the last month. As we pointed out a few weeks back – most trades are either spreads (with leverage), mean reversion or momentum. The Italy Germany spread appears to be the new hedge/spread trade on the block. In terms of momentum and mean reversion, German bund yields, while still at very low levels have broken back above a zero yield over the last month and from a technical perspective have broken through their long term moving average. Even Japan, which started the trend of getting paid to borrow money is now almost at zero, the Japanese 10 year benchmark bond is now at ‘only’ negative 5 bps. It too is very close to breaking its long term trend.
Generally speaking, when an asset class is both negative on a twelve month view and breaks its long term moving averages, it makes sense to move to hedge some of the possible downside risk – as momentum has gone and the probability of mean reversion is rising. Italian bonds already fulfil both criteria and while neither Germany nor Japan are negative in absolute terms, they are close to breaking trends. As noted last week, the US 10 year yield has already broken up through its long term trend. For commodities, oil (West Texas) at $47 is up slightly in absolute terms (2%) on the year, with a long term trend at $42, so looks ‘ok’ for now – although as we noted a few weeks back, it’s range bound rather than trending, while gold is still positive and holding above its trend line. The S&P 500 index is in a similar position – showing weakening short term momentum but still above its long term (small) uptrend, as are stocks that pay good dividends (and thus appeal to the search for yield).