mercoledì 6 giugno 2018

ECB Reacts (Unofficially) to NIRP’s Revenge in Italy

Bond turmoil, no problem. But if Italy doesn't stick to the rules, the ECB

 might let the bonds go, "safeguard the remaining Eurozone members,"

 and "merely control the disaster."

After dizzying plunges in the Italian government bond market on Monday and Tuesday, the ECB wasted no time communicating through unofficial channels: it's not stepping in for now, it's keeping an eye on the Italian bonds, but they haven't really plunged all that much yet, and yields aren't really that high, and there are no signs of stress in lending between Italian banks, and deposits are stable, and this isn't yet a big deal that would require ECB action.

They also said that the ECB had neither the tools nor a mandate to solve what it considers primarily a political crisis in Italy.

These envoys were "sources close to that matter," later described as "three officials," who talked to Reuters.

And this is what they were reacting to: The two-year Italian government bond yield had skyrocketed from near-zero to 2.8%, most of it on Monday and Tuesday. And today it fell back to 1.73%. This is an hourly chart of the past four days of bond turmoil:

The sources said that Italian government bond yields, reflecting the government's borrowing costs, were still less than half of their peaks during the debt crisis in 2011.

Recently the Italian government's debt office sold €1.8 billion of 10-year notes at a yield of 3.0%. So the cost of borrowing for the government has jumped from 1.7% at the last 10-year auction, but is still way lower than the 7.56% it paid in November 2011, during the peak of the Eurozone debt crisis. And it's just a little above what the US government currently would have to pay.

The debt office sold €1.7 billion in five-year notes at a yield of 2.325%, too. This is the most since 2013, but still low. And lower than what the US government would have to pay (2.66% currently).

At the end of May – on the worst day for Italian bonds in Eurozone history – the government sold €5.5 billion of six-month bills at an average yield of 1.21%. While that's up from negative yields in prior auctions, where investors absurdly agreed to pay the government for the privilege of lending it money, the yield is still massively below the US six-month yield of 2.06%.

And yields for maturities of three months and shorter are still negative. So the government has no trouble borrowing in this environment; it just has to pay a little more, an indication that the ECB's negative interest rate policy (NIRP) is beginning to phase out for Italy.

This is why the three envoys from the ECB told Reuters that the funding costs were still less than half of the costs during the debt crisis, that bank deposits were stable, and that there were no signs of stress in the interbank-lending market.

"No central bank would act on the back of the events of a few days," one source told Reuters.

"We're not yet at a stage when you have to start worrying about bank deposits and I hope we'll never get there," another source told Reuters.

This is not to say the ECB would never step in and aid Italy. In an interview with the Spiegel, published on May 29, outgoing ECB Vice President Vítor Constâncio, when asked if the ECB would intervene again as it had done in 2012, replied: yes, but there would be conditions – namely an "adjustment program" or commonly called austerity:

"I would like to stress that every intervention has to contribute to the fulfilment of our mandate and is also subject to conditionality. The Outright Monetary Transactions program for intervening in national sovereign bond markets of vulnerable countries can only be used if the country in question also agrees to an adjustment program. The rules are very clear on this. Everyone should remember that."

Spiegel: "So if Italy wants to circumvent the EU's fiscal rules, it can't necessarily count on the ECB's help?"

Constâncio: "I will only say that Italy knows the rules. They should perhaps take another close look at them."

But these rules are anathema to the two anti-establishment parties – the Five-Star Movement and the League which have been trying unsuccessfully so far to form a coalition government. The League has said that if its plan to lower taxes and raise spending (the opposite of austerity) isn't acceptable to the EU, it sees Italy's exit from the euro as a contingency plan. Hence, an "adjustment program," imposed on Italy in return for an ECB bailout, is not likely to happen if the coalition succeeds in forming a government.

Then the ECB might just let Italy's bonds go their own way and focus on preventing financial contagion in the remaining Eurozone member states, according to one of the sources who told Reuters: "The ECB could safeguard the remaining Eurozone members but it would be merely controlling the disaster."

And in that case, bondholders – mostly institutions – that hold Italian government debt would be left to negotiate with the Italian government on their own.

But that's not the case for now. And the bond market is not seriously speculating on this possibility either. It's simply normalizing yields, but doing so very swiftly, rather than gradually.

Markets wailed and gnashed their teeth on Monday and Tuesday as normalization of Italian yields set in.

World's Biggest Hedge Fund: "We Are Bearish On Almost All Financial Assets"

One month ago, in a surprising reversal, we reported that Bridgewater was outperforming peers this year even after losing money in April, largely as a result of a a massive derisking, i.e. turning bearish. As Bloomberg further added, "the fund has also reduced its net long bets on U.S. equities to about 10 percent of assets from 120% earlier this year, and that overall, the fund is net short equities."

And now we know why.

In one of Bridgewater's latest Daily Observations authored by co-CIO Greg Jensen, the firm writes that "2019 is setting up to be a dangerous year, as the fiscal stimulus rolls off while the impact of the Fed's tightening will be peaking" a point echoed yesterday by the head of the Indian central bank, Urjit Patel, who warned that unless the Fed ends its balance sheet reduction which comes as a time when the Treasury is soaking up dollar liquidity by issuing substantial amounts of Treasuries to fund the Trump budget, the tightening in financial conditions could lead to a global conflagration started by emerging markets.

And since asset markets lead the economy, Bridgewater continues, "for investors the danger is already here" and explains as follows:

Markets are already vulnerable, as the Fed is pulling back liquidity and raising rates, making cash scarcer and more attractive - reversing the easy liquidity and 0% cash rate that helped push money out of the risk curve over the course of the expansion. The danger to assets from the shift in liquidity and the building late-cycle dynamics is compounded by the fact that financial assets are pricing in a Goldilocks scenario of sustained strength, with little chance of either a slump or an overheating as the Fed continues its tightening cycle over the next year and a half.

To justify his point, Jensen notes that markets are pricing in that the world is pricing in a "goldilocks" world at the start of 2020, with 2.4% growth, 3.0% 10Y yields and 2.8% Fed Funds rates, which is essentially "an extrapolation of current conditions, with expected growth and inflation near perfect levels. The yield curve is priced to be flat, oil to be at $62, and the dollar to be down 3.5% against developed world currencies."

Looking at pricing dynamics, the world's largest hedge fund also notes that "expectations are for inflation to remain at fairly benign levels just above the Fed's 2% target, and options pricing reflects little investor demand for protection against the potential for the economy to bubble over. On the other hand, it also shows virtually no chance of deflation, which is a high likelihood in the next downturn."

Needless to say, Bridgewater is skeptical: "we doubt this picture of calm priced into markets will actually play out."

But what is most ominous, is Bridgewater's forecast beyond the end of 2019, when mysteriously most other permabullish projections are cut off. As Jansen writes, "while such strong conditions would call for further Fed tightening, there's almost no further tightening priced in beyond the end of 2019. Bond yields are not priced in to rise much, implying that the yield curve will continue to flatten. This seems to imply an unsustainable set of conditions, given that government deficits will continue growing even after the peak of fiscal stimulation and the Fed is scheduled to continue unwinding is balance sheet, it is difficult to imagine attracting sufficient bond buyers with the yield curve continuing to flatten."

With all of the above in mind, Bridgewater has one simple message: sold to you.

"We are bearish on financial assets as the US economy progresses toward the late cycle, liquidity has been removed, and the markets are pricing in a continuation of recent conditions despite the changing backdrop."

Don't worry though: Dennis Gartman remains bullish.