October 3, 2018 / 1:34 PM / in 17 days

"Quitaly" gauges flicker but don't flash as Italy heads for budget clash

LONDON (Reuters) - As bond investors stress about Italy’s budget plans, key market gauges of euro break-up risks are starting to flicker — but to a far lesser degree than they did just a few months ago.

Italian flags waves at the Vittoriano monument in Rome, Italy, June 5, 2018. REUTERS/Stefano Rellandini

Italy’s government appears set for a clash with the European Union, given its spending plans for 2019 and beyond.

Italy’s 10-year bond yield hit 4 1/2-year highs on Tuesday, gaining momentum after a lawmaker said most of Italy’s problems would be solved if it ditched the euro.

But in contrast to the brutal May selloff, market gauges reflecting risks of Italy leaving the euro zone — a possibility market players dub “Quitaly” or “Italexit” — are flickering rather than flashing.

1. CDS VS CDS

Italian credit default swaps (CDS), derivatives used to protect against exposure to a default, are considered more likely to pay out in event of “Quitaly”, if the contract was drawn up according to 2014 guidelines instead of earlier 2003 rules.

Therefore, the difference between how the two types of CDS trade is one gauge of whether markets are positioning for redenomination.

While the gap between the two contracts has spread, it remains below the width reached in May, when markets were roiled by fears of a snap election that could become a de facto referendum on the euro.

“It’s clearly not as bad as May. Italy doesn’t want to leave the euro,” said Rishi Mishra, interest rates strategist at Futures First Info Services.

(Graphic: reut.rs/2O4hWLK)

2. CACS IN THE CRADLE

How investors trade Italian bonds issued before and after 2013 is also telling.

That year, regulators introduced new rules stipulating that European government bond contracts contain collective action clauses (CACs). This means that majority bondholder approval is needed for a restructuring, including a change in the currency of payment.

In late May, bonds issued before 2013 – and therefore without CAC protection – sold off more sharply than debt issued after 2013; for example, the yield gap between Italy’s March 2022 bond issued in September 2011 and an April 2022 bond was 10 basis points.

(Graphic: reut.rs/2Pbwc1C)

Since then, the two issues have traded in lock-step, although this week has seen some signs of slight preference for the 2017 issue, suggesting a “Quitaly” premium may be creeping back.

3. NEW YORK OR ROME?

During the May rout, Italy’s two dollar-denominated bonds maturing 2023 and 2033 outperformed their locally-issued, euro denominated peers, as bonds governed by New York law offer stronger protection against restructuring, including currency redenomination.

However, yields on both types of bonds have risen since Italy delivered its budget deficit proposal last week.

 (Graphic: reut.rs/2QrquJf)

There are perhaps two explanations for this.

First, while the budget deficit forecast was higher than expected, it did not breach the 3 percent limit mandated by the EU, which would have raised questions about Italy’s commitment to the euro.

Second, overall rhetoric from top officials reaffirms Italy’s commitment to the euro.

“We think the key worry for markets right now is not an ‘Italexit’, but the impact from a wider fiscal deficit on Italy’s debt sustainability, especially given the backdrop of a fast-approaching end to ECB QE,” said TS Lombard senior economist Shweta Singh.

4. INFLATION STATION

Italy issues inflation-linked bonds, some pegged to euro zone inflation and others to Italian prices.

Demand for bonds pegged to euro zone consumer prices should have more demand than those linked to domestic prices because Italy’s economic growth and inflation lag the bloc.

But that doesn’t hold if a possible redenomination comes into play, because a new Italian currency would probably fall, fuelling inflation.

So buying Italian inflation is a clean hedge for redenomination risk. In May, yields and break-even levels on Italy’s May 2023 bond pegged to euro zone inflation and May 2023 bond pegged to Italian inflation were almost identical.

(Graphic: reut.rs/2OvKLA8)

In September, when hopes were for a market-friendly budget, the spread between the real yield of the two bonds widened to nearly 30 basis points. It has now narrowed back to just 6 bps.

5. LOVING THE SCHATZ

German two-year government bonds — the Schatz — are a favourite with investors nervous about a euro zone break-up.

Bonds from top-rated Germany, the euro zone’s biggest economy, are viewed as some of the safest assets in the world.

Short-dated bonds also tend to benefit from near-term risks and are seen by some as a proxy for the how the deutsche mark would trade should it return.

The Schatz yield hit a one-month low at almost minus 0.60 percent on Tuesday as Italian bonds sold off.

(Graphic: reut.rs/2OxmAkZ)

In May, two-year yields tumbled far more, hitting one-year lows, slid to record lows ahead of French elections last year and dived after Britain’s Brexit vote in 2016.

“This does seem to be seen as an Italian-specific issue rather than a systemic issue for Europe,” said David Zahn, head of European fixed income at Franklin Templeton.

Reporting by Dhara Ranasinghe and Abhinav Ramnaryan; graphics by Ritvik Carvalho; editing by Sujata Rao and Larry King

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