Italian Banks Are Dumping Italian Sovereign Debt To The ECB Ahead Of The Election

At the turn of the year, and just over 2 months ahead of the Italian elections on March 4, we presented a stunning observation from Citi, one suggesting that even before any potential political risk emerges in March, private investors had long ago fallen out of love with Italian BTPs and had taken to the hills.

As illustrated in the chart below, just about every other major investor type has become a net seller (to the ECB) or a non-buyer of BTPs over the last couple of years. Said differently, for well over a year, the only marginal buyer of Italian bonds has been the ECB (dark blue).

Then, overnight, Jefferies was kind enough to collate the latest ECB sovereign debt flows data, and revealed another stunning finding: one of the biggest sellers to the ECB has been none other than Italian banks themselves!

Here is Jefferies analyst David Owen:

The breakdown below shows significant moves by the banks in all four largest euro area economies. However, the Italian banks are again in the spotlight; they reduced their domestic sovereign debt holdings by a hefty €12.6bn in December, and by €40bn (10.5% of outstanding stock) in Q4 as a whole. There is strong seasonality in the data, as banks book trading profits and dress-up their balance sheets for year-end; but even by previous standards, this move in recent months is unprecedented.

It is indeed, and as a side note, since the start of European QE, some €100 billion in Italian bonds have changed ownership: from Italian banks to the European Central Bank .

On one hand, this is good news as it suggests that Europe's "doom loop" is finally breaking. Recall that the biggest risk facing Europe in the 2011-2013 period was the surging purchases of their own sovereign debt by local banks, which were too afraid to put money into other non-backstopped assets. And, according to some, the resultant record holdings is one of the reasons why the ECB launched QE: to send the prices of European sovereign bonds soaring, unblocking European bank balance sheets and allowing the traditional credit machinery to work again.

The flip side is that while European banks have been selling sovereign bonds, they have been shifting the proceeds into other, far riskier assets, assets which will tumble the moment the market prices in the departure of the ECB as Europe's buyer of last resort.

And while it is unclear how long until that moment of epiphany occurs, keep an eye on Italian banks and their BTP holdings: once the reduction reverses, and banks start bidding up, it's safe to assume that Draghi's next QE program can't be too far behind.

As for the political risk, and potential fallout from the upcoming Italian elections, fear not: by now the ECB is surely one of the biggest owners of Italian bonds, and if something unexpected happens, well Draghi will always pull something out of his sleeve, "whatever it takes."

"If the Fed Is Right, Then Markets Are in Trouble"

Defying the best efforts of central banks over the last nine years, inflation has yet to rear its head. Although many would welcome inflation growth above 2 percent, the markets are flashing warning signs that a return to pre-crisis levels might not produce the expected results. Instead, such an increase could bring volatility, which is often a code word for falling markets.

On Jan. 25, 2012, the Federal Reserve aimed for 2 percent core personal consumption expenditures as a desired level of inflation. As the chart below shows, inflation has mostly remained well below this target. That was bad timing on the Fed's part.

The Fed's inability to create inflation has flummoxed Chair Janet Yellen, who led the last meeting of her tenure on Wednesday. As the following two citations show, the "data-dependent" Fed chief was reduced to the words "guess," "expect" and "believe."

On Oct. 15, 2017, she said:

My best guess is that these soft readings will not persist, and with the ongoing strengthening of labor markets, I expect inflation to move higher next year. 

And on Dec. 13, 2017, she said:

I've talked in detail about this in the past and recognized that there is uncertainty about what's holding inflation down, but my colleagues and I continue to believe that the factors that are responsible this year for holding inflation down are likely to prove transitory. 

The markets have also struggled to forecast inflation correctly. The chart below shows the U.S. 10-year inflation breakeven rate, or the market's expectation for the average inflation rate over the next 10 years. Between 2010 and 2013 the market regularly thought inflation was returning, but it never did. A year ago, it also thought so, but that didn't happen, either. And the market thinks inflation is returning now.

While subdued inflation has thoroughly confused many economists and traders, the markets are exhibiting some peculiar behavior about its eventual return that may give investors reason for pause.

The chart below shows a rolling six-month correlation between the implied volatility of various assets and U.S. 10-year Treasury Inflation-Protected Securities inflation breakeven rate. Equities (red), U.S. Treasuries (cyan), and foreign-exchange (orange) are seeing a swift end to their negative correlation between volatility and inflation expectations.

To see the trend better, the next chart shows the average of the correlations depicted above. It is poised to move into positive territory for the first time since July 2007. In other words, higher inflation may bring with it higher volatility for the first time in almost 11 years. But the concern is that volatility is often a signal of declining markets.

The relationship between inflation expectations and asset prices is also changing.

The next chart shows a rolling six-month correlation between stock prices and inflation. It is falling, as would be expected when the Fed is tightening. The correlations are now heading toward zero. Should they too flip to negative, further increases in inflation expectations would coincide with lower returns on risk assets.

Proclamations of inflation's triumphant return have been frequent in the last decade. So far, these have all been false alarms. Nonetheless, markets are once again sending that signal.

Throughout the post-crisis era higher inflation expectations have coincided with lower volatility and higher risk asset prices. We believe the assumption that this relationship continues explains why so many forecast, or want to see, inflation's return. It signifies a strong and robust economy that financial markets should want. However, this relationship is on the verge of flipping. Higher inflation expectations may soon be a recipe for higher volatility and lower risk asset prices, as they were precrisis and especially in the 1970s to 1990s.

Central banks and traders should be careful what they wish for.