Hedge funds have lined up the biggest bet against Italian government bonds since the global financial crisis on rising concerns over political turmoil in Rome and the country’s dependence on Russian gas imports.
The total value of Italy’s bonds borrowed by investors to wager on a fall in prices hit its highest level since January 2008 this month, at more than €39 billion, according to data from S&P Global Market Intelligence.
The rush by investors to wager against Italy comes as the country faces rising economic headwinds from the surge in European natural gas prices prompted by Russia’s supply cuts and a fraught political climate with elections looming in September.
“It’s the most exposed [country] in terms of what happens to gas prices, and the politics is challenging,” said Mark Dowding, chief investment officer at BlueBay Asset Management, which runs about $106 billion (€106 billion) in assets. He is shorting Italian 10-year bonds using derivatives known as futures.
The IMF warned last month that a Russian gas embargo would lead to an economic contraction of more than 5 per cent in Italy and three other countries, unless other nations shared their own supplies.
Italy is also considered by investors to be among the most vulnerable countries to the European Central Bank’s decision to unwind its stimulus programmes by raising interest rates and halting the bond purchases that have propped up the country’s vast debt market.
Domestic credibility goes hand in hand with international credibility— Mario Draghi
A period of relative political calm ushered in by Mario Draghi’s appointment as prime minister in February 2021 was shattered in July this year when the former ECB chief resigned and his national unity coalition administration unravelled.
Early elections are now set for September, with nationalist leader Giorgia Meloni considered the front-runner to become next prime minister. On Wednesday, Mr Draghi called on parties competing in the elections to make good on Italy’s financial reform commitments.
Eurosceptic parties within the right-wing coalition, which could secure up to half of the vote on September 25th, according to polls, have signalled that they could review the details of Italy’s €200 billion EU-funded recovery plan and the other reforms such as a new competition law associated with it.
“Domestic credibility goes hand in hand with international credibility,” Mr Draghi said.
Italian bonds have already sold off in recent weeks as investors respond to the rising uncertainty. The yield on Italy’s 10-year debt has risen to 3.7 per cent, pushing the gap, or “spread”, with Germany’s debt — a key risk barometer — to 2.3 percentage points from 1.37 percentage points at the start of the year.
One large investor in hedge funds said “Italy seems like it’s going to be the most vulnerable” country to worsening economic conditions, adding that such bets were now “widespread”, with many managers playing the spread between German and Italian bonds.
Michael Hintze, founder of hedge fund CQS, has been among those profiting from bets against Italy’s bonds earlier this year, according to documents seen by the Financial Times. CQS declined to comment.
Betting against Italian debt has previously been a highly lucrative trade for hedge funds because of long-running political uncertainty and fears over the €2.3 trillion in government bonds that the country has outstanding.
In 2018, as markets fretted about whether a coalition government would add to debt levels and loosen ties with the EU, hedge funds ramped up their bets to the highest level since the financial crisis, with Brevan Howard co-founder Alan Howard among those profiting. However, hedge funds’ bets, both in absolute terms and as a proportion of the total bond issuance, have now overtaken 2018 levels in a sign of where investors believe yields could go from here.
Some managers remain wary of the trade, saying that the ECB’s recently announced transmission protection instrument will limit upside to yields. The new tool was designed to keep borrowing costs in highly indebted euro zone countries from rising too far above core nations such as Germany.
“It seems to me [it’s] like playing a game of chicken with the ECB,” said Decio Nascimento, chief investment officer at hedge fund Norbury Partners, who is avoiding the trade.
However, BlueBay’s Mr Dowding argues that the TPI is little deterrent to placing a bearish bet.
“[The ECB] can’t just buy Italy,” he said, adding that such a move would act as a signal that the central bank would provide support to countries lacking fiscal restraint. — Copyright The Financial Times Limited 2022