SHORT FIXED INCOME MARKET COMMENTARY, JUNE 2018

Italian Politics and Treasury Volatility

Hopefully, as the major and minor financial crises of the last decade recede further from our collective memory, investors and markets will retain the hard-won lessons learned from the past. The lesson I learned was to not go into Finance in the first place. But being deep into my forties when the financial crisis hit and possessing few technology skills beyond the phone number of our tech support team, my path was pretty well set. So instead, we forged ahead and tried to incorporate these experiences into our investment and risk management processes.

Which brings us to Italy - that most unwelcome reminder of the European debt crises of 2011 and 2012. Recent Italian elections saw anti-establishment parties make strong gains in Parliament and introduced the possibility of a vocal euro- skeptic becoming finance minister. Markets quickly bid up the potential - albeit still small - for an Italian exit from the European Union (EU), sending risk assets lower and U.S. Treasury prices soaring. I think the market got the direction right - equities and credit spreads shouldn't really rally on such news - but the magnitude of the move in two-year Treasuries was eye-popping. Yields were down almost 16 basis points (bps) on May 29th and a full 26 bps from the May 16th high, during a period when signs point toward higher policy and yield curve rates. For the most part, markets recovered rather quickly after Italian politicians talked down the prospect of an Italian EU exit. But we were reminded of a few of our previous lessons learned: a) interest rates do not travel in a straight line to their destination, b) markets react quickly and often viciously when unexpected risks arise, especially when those risks can be extrapolated into a dire outcome like the dissolution of the EU, and c) worst-case scenarios are a tough business to trade.

On the last point, those who were long risk assets and short duration going into the May 25th Memorial Day weekend would have been well served staying out of the office and playing golf or whatever it is people who are long risk assets do on an extended weekend. I, of course, was back at my desk on Tuesday diligently watching our short-duration strategy get kicked around for the day. While the ratcheting up of risk expectations on the election results was rational, our team felt the extrapolation to global central bank accommodation and, in turn, a short-circuiting of future Fed rate hikes was premature. To us, the magnitude of the move in rates felt more like some traders were caught offside and paying the price, rather than a secular change in interest rate policy or a panicked flight-to-quality trade. In these circumstances, the best strategy is to keep debt purchases very short and avoid locking in lower yields by adding duration. And if you have a future need to raise cash, for heaven's sake do it now before rates recover. Because event-driven interest-rate markets can and often do recover quickly - illustrated by the nine bp jump in two-year yields the very next day and the near full recovery to May 25th's 2.478% yield by week's end. Those lucky golf-playing stiffs returned from their extra-long weekend wondering what all the fuss was about and who the heck Paolo Savona is.

As you would expect, credit spreads behave differently than yield curve moves. Risk events - both small and large - tend to spook credit investors, who then demand higher yields as compensation for the perceived increase in risk, often resulting in a quick and meaningful widening of spreads. Recoveries in spreads tend to be far more grinding and over a longer period of time. That marvelous old investment adage - Markets take the stairs up and the elevator down - is a perfect description of how credit spreads move.

From a credit quality standpoint, I feel comfortable saying few, if any, principal preservation portfolios have direct exposure to Italian sovereigns or banks. We certainly don't. But as we have all learned, direct exposure is not the only risk worth considering. Contagion risk can leak into portfolio credits which may have exposure to Italy in some form or another, widening spreads and impairing issuer / sector liquidity. Here, fundamental credit research is key to understanding issuer risk and is especially important for the banking sector, which is particularly susceptible to declines in market confidence. Ideally, vulnerable issuers are identified and avoided, allowing us to watch events unfold from the sideline.

Unfortunately, there would be no sidelines for the fallout from the break-up of the EU. Such an unlikely and monumental out-of-the-box event would damage equity and risk assets across the globe, spark a massive flight-to-quality trade and trigger forceful central bank action - all of which would move against our current strategies. No question, Italy has severe debt and growth problems which have not been resolved and are being masked by the generous bond buying support of the European Central Bank. We do not dismiss these Eurozone risks, but we sincerely doubt the worst case scenario is this year's business. For now, we remain focused on the strengthening U.S. economy, fiscal policy-influenced capital flows and further Federal Reserve rate hikes to develop our investment and yield curve strategies.

 

 

Source

Bloomberg