Italian Junk Food.

Remember “Pulling The Punchbowl When The Espresso Is Hot And The Economy Is Cooling“?

If not, that’s ok. That post was from two weeks ago and you’ve slept (and hopefully been drunk) since then. That was a kind of rambling piece which, as I would later detail, was penned while attempting to block out the noise from a literal outdoor aerobics class that convened around me unexpectedly (I sometimes write from a picnic table at a pavilion down by a local pier and unbeknownst to me, one local fitness instructor has decided that this tourist season, she’s going to commandeer that pavilion for her classes, presumably because it has a nice ocean view). In it, I talked about the Italian “problem” in the context of ECB CSPP.

The overarching point was that Italian debt isn’t exactly trivial in terms of its representation in the € IG and € HY markets:

Key to keeping a lid on € credit spreads is successful forward guidance from the ECB. “Successful” just means keeping the market in the loop and not delivering anything that approximates a hawkish “surprise.” That effort is in the service of keeping rates volatility suppressed, as rates volatility is what will ultimately determine whether and to what extent € credit spreads blow out.

So (and I’m actually quoting myself here from yet another post), the risk is that thanks to Italy’s reasonably high representation in the € HY market and non-trivial representation in € IG, you could get a kind of double whammy effect if the ECB bungles the message.

That is, if they inadvertently send an overly hawkish signal that causes rates volatility to pick up, that could weigh on credit in two ways: through the market’s straightforward assessment that the end of APP is nigh and rate hikes are “quarters not years” away (to quote Villeroy) and also through a kind of second-order effect whereby folks start to question what the read-through for € credit as a whole is (given the representation shown in Charts 11 and 12 above) if the ECB is rolling back support for Italian assets just as the political situation clouds the outlook.

Again, that assessment is from two weeks ago and it goes without saying that since then, shit’s gone to hell in a handbasket (the late week rally in BTPs and Italian equities notwithstanding).

I did a followup to that post called “One Bank Discovers A ‘Staggering’ Stat Amid Italian Bond Selloff” that quoted a recent note from BofAML’s Barnaby Martin who, picking up where he left off earlier this year, noted that the percentage of Italian credit trading inside of similar maturity govies stood at a rather remarkable 90%:

Well, fast forward to this week and BofAML’s HY teams (i.e., both in the U.S. and in Europe) are out discussing the extent to which, thanks to Italy’s representation in € HY, weakness in Italian credit could indeed drag the entire index lower.

“Currently, Italy still accounts for 17% of the overall HY index, making it important enough to move the overall HY spreads following the political upheaval now taking place,” the bank’s European HY strategists write. Here they are tracing the evolution of Italy’s representation at the broader € HY index level:

In high yield, Italy has always been of cardinal importance. As shown in Chart 2, Italy reached as high as 23% of the total outstanding of HY back in 2013 and 2014, but the importance of it as a domicile dwindled gradually following upgrades, deleveraging operations or refinancing via other routes, for example loans. And as mentioned in our HY Reverse Yankees report, the increase in issuance from non-peripheral issuers also played an important role in diluting the importance of Italy in HY, while increasing that of Core countries and US and Japanese issuers.

My contention (as documented extensively in the posts linked above), is that eventually, Italian credit will sell off to close the gap with BTPs as it simply isn’t realistic to assume that 90% of the market can continue to trade rich to sovereigns. Even if you think corporates are actually safer credits than bonds issued by a populist government hell-bent on fiscal profligacy, surely to God 90% of Italian credits aren’t less risky than similar maturity government bonds. When you factor in the potential wind down of CSPP and consider that, all else equal, the ECB could ultimately choose to divert whatever’s left of APP after September’s assumed taper to supporting BTPs (at the possible expense of a CSPP bid for credit), well then you’ve got to think the gap would close.

Well, as BofAML’s U.S. HY credit team writes in a separate piece, “the yield differential between EUR HY and Italy 5yr bond [fell to] the tightest it has been throughout the whole history of the EU sovereign crisis, going back to 2010” this week:

As you can see (i.e. the bounce from below 1 to 1.74), things got a bit “better” (i.e., the spread widened back out as Italian yields fell late in the week), but as the bank goes on to write, “it still has 50-75bps to go from here to match the low range established twice over the past eight years, in 2013/2014 and 2017.”

Clearly, this suggests € HY will widen out, especially “given the newly opened yield alternatives in Italian sovereigns”, BofAML continues, before driving things home by reiterating that while “EUR HY is not all about Italy, Italy is its largest component.”

Finally, the bank’s European strategists remind you that junk is sensitive to shocks. “Time and time again, we’ve seen high yield move in tandem with idiosyncratic events,” they caution, adding that “political events have an even greater contagion impact when it comes to HY.”

Take all of that for what it’s worth, but generally speaking, this is just the latest example of the distortions wrought by ECB QE (i.e., ridiculously low yields in EUR HY) colliding with precarious political dynamics across the pond to create distortions and unpredictable dynamics.