Italy Bond Rout Driven by Liquidity Vacuum as Buyers Vanish

(Bloomberg) -- The free-fall in Italy’s debt Tuesday underscored that even one of Europe’s biggest debt markets is subject to the traders’ adage that liquidity often dries up just when you need it most.

The country is struggling to form a government more than two months after its last parliamentary election and fear that populist parties could turn a repeat poll into a de facto referendum on euro membership have sent yields surging in Italy’s 1.6 trillion euro ($1.85 trillion) bond market.

With liquidity thinned and a lack of willing market makers, the yield premium on 10-year notes over similar German securities climbed to 323 basis points, a level unseen since April 2013. The sheer size of the gyrations may also have provided further impetus, with financial institution risk models potentially prompting forced selling by some investors.

“This isn’t a deep liquid market anymore,” said Peter Tchir, the New York-based head of macro strategy at Academy Securities Inc. “Everyone was overweight, positioned long Italian debt and the price declines created a hot potato down in prices. The volatility was so insane that people’s risk managers likely just told them you have to cut these positions.”

Helping to escalate investor fear was the fact that the European Central Bank, the region’s most captive and price-insensitive buyer, may be stepping away from the market later this year, Tchir said.

BlackRock’s Scott Thiel, who has been short Italian bonds, or BTPs, since before Italy’s March 4 vote, on Tuesday cited poor trading volumes as being behind the “extraordinary” moves in the securities.

The political turmoil in Italy is at such a fever pitch that it is rekindling memories of the euro area’s woes of the past decade. Billionaire George Soros, who warned of a looming financial crisis and an existential threat to the European Union, is shorting stocks from Stockholm to London.

An unwinding of so-called carry trades, which benefit from interest-rate differentials and tend to do best in calmer markets, may also be adding pressure. Rising volatility on the returns from Italian bonds caused investors who were long the country’s sovereign debt to dump their holdings, according to a hedge fund manager who declined to be identified as he wasn’t authorized to speak publicly.

The latest Italy-related disruption comes in the wake of turmoil that’s roiled emerging-market currencies, including the Turkish lira. It also follows an episode of heightened U.S. equity market volatility back in February that saw a spike in indexes such as the CBOE Volatility Index, or VIX, a widely watched Wall Street fear gauge.

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“The Italian bond market is reflecting a shift higher in concerns of re-denomination risk,” said Chris Chapman, portfolio manager at Manulife Asset Management. “The moves were probably exacerbated by thin liquidity. Italy does have a large market, but I think overall there’s less Street liquidity, particularly in times of market stress. Electronic trading becomes less fluid.”

Liquidity Event

There is a chance that, even with the increase in political turmoil, Tuesday’s sell-off was more a liquidity event in which buyers simply vanished than a fundamental reassessment of the value prospects for Italian debt.

“The worst fears of Italy leaving the euro or Spain having a non market friendly government have very few chances to materialize,” said Zev Marynberg, chief investment officer of macro hedge fund Adar Capital Partners, which manages $1.3 billion in assets. It’s an overreaction to recent news in Italy and Spain and essentially nothing has changed, he said via email.

While Spain’s economic growth outlook appears more favorable than Italy’s -- and its bonds have held up better than those issued by the government in Rome -- the country faces its own political unrest following a no-confidence motion against Prime Minister Mariano Rajoy.

For Italy, the risk is that contagion spreads as in other crises, hurting banks that are in the process of shoring up their balance sheets and reforming. Italian bonds rebounded Wednesday, with two-year yields dropping 74 basis points to 2.02 percent, ahead of 6 billion euros of supply.

“If Italy goes into a deeper and prolonged crisis, it could seriously impair the offloading process of non-performing assets from banks as buyers would likely shy away from this market,” said Nicolas Roth, head of alternative assets at Geneva-based investment firm Reyl & Cie by email.

Market Winners

Of course, the turbulence radiating from Italy is not bad news for everybody. The macro credit hedge fund overseen by Algebris Investments’ Alberto Gallo is benefiting from its bearish wagers on Italian bonds, while Bridgewater Associates and Marshall Wace have been making a killing on their wagers against financial stocks in Italy.

And in the Treasuries market, speculators who last week tilted long in two-year note futures for the first time are also reaping a windfall. The escalating crisis in Italy spurred a hunt for havens that on Tuesday dragged yields on the securities down by about 16 basis points to 2.32 percent. Markets began to calm down overnight in the U.S. The panic moves retreated slightly as the 10-year yield rose 5 basis points and the 2-year gained 6 basis points.

“Other than in U.S. Treasuries it just seemed like there was nowhere else to hide Tuesday,” said Tchir.

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