Quitaly indicators flash but do not blink, Italy prepares for budget conflict

LONDON (Reuters) – While bond investors are worried about Italy's budget forecasts, the main indicators of the euro's risk of a break in the market are starting to blink, but to a much lesser extent than a few years ago. month.

The Italian government seems ready to face the European Union, considering its spending plans for 2019 and beyond.

The yield on 10-year Italian bonds on Tuesday reached 4 and a half year highs, gaining momentum after a lawmaker said most of Italy's problems would be solved if the euro was abandoned.

But unlike the brutal sell-off in May, market indicators reflecting the risks of Italy's exit from the euro zone – a possibility that market players dubbed "Quitaly" or "Italexit" – are glittering rather than flash.

1. CDS VS CDS

Italian credit default swaps (CDS), derivatives used to protect the risk of default, are considered to be more likely to pay in case of "Quitaly", if the contract was established in accordance with the 2014 guidelines instead of the rules prior to 2003 .

As a result, the difference between the way in which the two types of CDS trades are traded makes it possible to determine whether the markets are positioning themselves for redenomination.

Although the gap between the two contracts has narrowed, it remains below the width reached in May, when markets were shaken by the fear of an early election that could become a de facto referendum on # 39; euro.

"It's clearly not as bad as May. Italy does not want to leave the euro, "said Rishi Mishra, interest rate strategist at Futures First Info Services.

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2. CACS IN THE CRADLE

The way in which investors trade Italian bonds issued before and after 2013 is also revealing.

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

At the end of May, bonds issued before 2013 – and therefore without protection from the ACC – were sold more heavily than debt issued after 2013; for example, the yield spread between the Italian bond issued in September 2011 and the April 2022 bond was 10 basis points.

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Since then, both issues have traded at the speed of lightning, although this week has been marked by signs of slight preference for the 2017 edition, suggesting that a premium " Quitaly "may well be restored.

3. NEW YORK OR ROME?

During the May rout, Italian dollar-denominated bonds maturing between 2023 and 2033 outperformed their locally denominated euro counterparts, with New York-law obligations offering better protection against restructuring, including the redenomination of money.

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

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There may be two explanations for that.

First, although the projected budget deficit was higher than expected, it did not exceed the EU's 3% limit, which would have raised questions about Italy's commitment to -vis the euro.

Secondly, the general rhetoric of senior officials reaffirms Italy's commitment to the euro.

"We believe that the key worry of the markets at the moment is not an" Italexit ", but the impact of a larger budget deficit on the viability of the Italy's debt, especially given the imminent end of the ECB's QE, "said senior economist of Lombard TS Shweta Singh.

4. INFLATION STATION

Italy issues inflation-indexed bonds, some indexed to inflation in the euro area and others on Italian prices.

Demand for eurozone consumer-index-linked bonds is expected to outpace demand for domestic prices, as economic growth and inflation in Italy lag behind the bloc.

But this does not hold if a possible redenomination comes into play, as a new Italian currency would probably fall, fueling inflation.

So buying Italian inflation is a good protection against the risk of redenomination. In May, the yields and the break-even points of Italian May 2023 bonds indexed to euro area inflation and May 2023 to Italian inflation were almost identical.

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In September, while hoping for a market friendly budget, the gap between the real yield of the two bonds widened to nearly 30 basis points. It has now been reduced to just 6 basis points.

5. LOVE THE SCHATZ

The two-year German government bonds – the Schatz – are highly appreciated by investors, worried about the dissolution of the eurozone.

Germany's higher-rated bonds, which represent the largest economy in the euro zone, are considered one of the safest assets in the world.

Short-term bonds also tend to take advantage of short-term risks and are seen by some as an indirect indicator of how the German mark would trade in the event of a return.

Schatz's yield hit its all-time low in a month at almost minus 0.60% on Tuesday, as Italian bonds sold.

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In May, two-year yields fell sharply, reaching their all-time low in a year, their record low before last year's French elections, and plummeted after Britain's Brexit vote in 2016.

"This seems to be perceived as a specific problem in Italy rather than as a systemic problem for Europe," said David Zahn, head of European fixed income at Franklin Templeton.