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Why have Italian bond yields increased so much last week?

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Following a few questions from clients regarding the surge in Italian bond yields in the last week, I have put together a quick overview of why this has taken place.

Bond yields are the return an investor is going to earn for investing its money in government bonds. The better the outlook of a country’s economy, the safer the investment will be and the lower the requested return from investors, hence a lower yield. Therefore, bond yields are inversely related to their price and the perception of strength within a country’s economy.

The issue with Italy is the fact that the Italian populist government announced a more fiscally aggressive deficit budget than was anticipated. This budget was out of EU-mandated guides, which spooked investors, as Italy is under enormous pressure to control its financial position because its debt-to-GDP stands at more than twice the eurozone’s permissible limit.

If Italy’s spending is not controlled, it could face a Greek-style debt crisis, putting a lot of pressure on the EU to control Rome’s budget indiscipline.

Despite an announcement on Wednesday the 3rd of October, where the Italian government gave in to EU pressures and reduced the spending deficit for the next 3 years, the sentiment regarding the safety of the Italian government is still very low. This is evident because the spread between the Italian 10-year bonds and the German 10-years bonds, which act as a benchmark for sovereign risk, rose more than 300 points last week, the highest level since March 2014.

This increase in government yields proves that investors are weary of the Italian government’s ability to stick to EU guidelines and believe the Italian economy is very unstable, therefore requiring higher returns to compensate for the uncertainty.

I hope you find this piece clarifies the current events, if you have any questions just ask. Feel free to "@" me in your discussions.

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Very interesting post and very top level stuff! The old bond market trading strategy certainly isn't something you come up to on a daily basis - generally because you need such mad volume to trade it - and although I sometimes find it hard to get my head around I do like to read up on it. Very Macro stuff, and enjoyed it in the EMEA brief last week sometime.

Seems to be having a significant knock on effect to the euro at the moment so possibly we'll get some insight and weight in from @Mercury who wrote a pretty good FX piece. From a fundamentals perspective it seems the weakness in indices seen in China and worldwide for that matter has also had a knock on.

Back to bonds! You noted a spread trade which is pretty interesting. The ol divergence between two assets is kinda interesting and something I did a while back - maybe 2 years ago - when we had the oil price volatility. I can't remember the exact trade, but it was a simple 'buy brent/sell WTI' as the prices of the two came very near (and possibly briefly touched) which was well out of their usual movements. Now for example you can see a near $9 difference between the two, whilst before that came down to mere cent.

Anyway, there was also this chart I saw on reuters which backs up the above.

2OP5C1o.png.5d984b66bc005800b6f0b7d986782887.png

Over the weekend it seems that the key Italian political figures have made it clear theyre in no mood to negotiate with the EU - its mental. Doen't this mean we could be looking at downgrades to government debt and credit ratings? Are these things scheduled at all or can they come out ad-hoc?

side note: should there be a bit of a bigger gap between economists and politicians?!

Edited by cryptotrader
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Can you deal on the bond yields on IG? 

Edit: possibly a stupid question...

Edited by PandaFace

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Not sure I have much to add to this @cryptotrader I am not strong on the bond market and don't trade it.  Main reason being I can't get charts with sufficiently long term data to analyse.

FWIW my received wisdom on bonds generally is as follows:

  1. The bond market (corporate and government) is much larger than the stock market and therefore important to watch if you are trading stock indices because it is a big influencer - why? because Gov bonds are indicative of economic health generally and corporate bonds are where companies get the majority of their funding for growth projects (or more laterally for share buy backs and M&A...)
  2. All of the major stock market crashes were presaged by bond market falls, indeed the bond markets fell further and caused more mayhem than stock market crashes but the latter gets all the media attention because the average news consumer understands stock market crash but hasn't a clue what bonds are.  (consider the credit crunch and the 1987 Black Monday crashes and you will see they were bond market driven).
  3. Bond price moved inversely to the respective Yield curve.  When rates go up prices go down and vice versa, this is simple maths really.
  4. Bond yields drive interest rates (Central bank and commercial) not the other way around.  This is not intuitive as most people would assume that central banks set the rates but the bond market is global and massive and a free market environment so actually when you think about it from that perspective it is the buyers and sellers of bonds, in particular government bond issues, that set the rate.  Central banks have to change their rate to get their government issues away r the respective countries run out of funds.
  5. If you look at the yield curves on US30 yr and 10yr you will see a bottoming out and rise on yields.  10yr has already made new highs over a 5 year horizon, 30year still has a bit to go.  Central Banks have followed suit (note followed not led).  In other words interest rates are on the rise.
  6. Higher interest rates = high cost of capital for companies and makes holding cash/bonds more attractive for investors vs stocks.  But Bond prices are very high and dropping as yield goes up...  Still the people who must hold bonds (Pension funds), and held even ZIRP and NIRP bonds, will continue to buy bonds because they have to.  They will continue to buy even as prices drop to get the yield return.

The specifics of a divergence (and as an analyst I love a bit of divergence) as seen between Italy and German in the chart posted by Cryptotrader suggest to me something I have held as a strong believe for a long time, which is that the Euro is flawed (see video posted by @Caseynotes recently).  Germany is a much stronger economy so they can get away with a lower interest rate than Italy.  But they both operate in Euros...!  Also note that both yield curves are rising!

My conclusion is that Bonds will once again lead the stock markets down and it is already happening, just not making the news because the media report events after the fact and focus on stuff that resonates with the masses.  We may even get some hyperbola from the mainstream media about how stocks are going to rocket to the moon before the end, and that would be a classic contrarian sell signal!  Also the divergence in yield within the Euro zone suggests a Euro meltdown, which also fits with my assessment of EURGBP!  Despite doom and gloom about Brexit.

@PandaFace if you want to trade bond yields long then I think you have to trade bonds short which is the exact inverse.  Not sure about an actual yield offering by IG, you would have to ask, but I have never seen one and nothing is listed in the menus, except Fed rate, which given the lag might not be a bad option...  Not for me though.

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Regarding your question @PandaFace, we do not currently offer bond yield to trade on IG. We offer a selection of bonds, one of them being the Italian BTP. During the last 20 days we have seen a 7.31% movement in the market of the BTP offering a good level of movement for trading.

I will attach below a document that shows the product details just in case you are interested in trading the Italian BTP.

https://www.ig.com/uk/help-and-support/spread-betting-and-cfds/fees-and-charges/what-are-ig-s-bonds-spread-bet-product-details

 

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Thanks Daniela. Thinking about it trading yields doesn’t make any sense whatsoever... ??‍♂️

Edited by PandaFace

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@Mercury - honestly that was some very interesting and insightful bullet points there. I would suggest that everyone reading this post - even if they don't have much time - looks against specifically at those points of wisdom and take from it what you will. Also the original post @DanielaIG - v useful.

As with all things in finance, you need to have your finger in every pie because they are allllll connected. To give a quick summary if I may M.

  1. watch the bond markets as they're indicative of economic health (even if you only trade equities/indices)
  2. All of the major stock market crashes were presaged by bond market falls
  3. Bond value increase causes yield decrease
  4. Yields drive interest rates - keep an eye going into central bank IR decisions
  5. central banks follow yield (reiterated a bit here / lsot on me)
  6. High rates = high cost to borrow and therefore could indicate sell offs

likes and thumbs up to the above plz

Edited by cryptotrader
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Interestingly Italian bonds are trading at a double rating when viewed from a yields perspective. Credit to BondVigulantes for that one, but very interesting to see such a divergence when paired against the rest. Rating agencies such as Moody's may be likely to cut rankings, however despite a potential volatility blip, is looks like this is pretty much priced in. 

DpIzQSgXcAEOkIY.jpg

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