TRADING THE ITALIAN YIELD CURVE

I'll start out today with my most substantive thought. It will constitute most of this note. My methodology here won't be rigorous; my intention is not to meticulously prove that a given idea is valid or that a trade is worth making, but to collect my thoughts and perhaps pass on some knowledge as I go. So I warn you in advance: it will be messy.

Now I'm not a FT yield curve trader by any stretch, but BNP's rates team got me thinking yesterday about some recently 'naughty' behavior by the Italian sovereign curve's shape (i.e. curve shape not moving as one would expect). To put it mildly, there has been some steepening:

See that nearly 100bp move in 15s, and the perhaps more interesting 60ish bip move in 5s? Yeah I wouldn't have predicted that either. Gotta love bbg's GC <GO> function – it's very easy to see exactly what has been happening in each box, and get a feel for exactly how the steepening has played out across tenors. But the conclusion isn't hard to grasp: the curve has steepened.

And so, as an innate contrarian, when I see that steepening I want to bet on a flattening!

But then the gears starting to really grind, and I became puzzled by why this was happening. One of my first thoughts was that I know Italian rates trade extremely tightly with Spanish rates, and that their respective steepnesses rarely diverge by much. But look what's happened to that tightness since the end of last year. This presumably has to do with Italian political uncertainty exceeding Spanish political uncertainty. A useful conclusion from the Spain vs. Italy comparison is that we can confidently exclude the possibility that the relative steepness is a 'periphery vs. core debt thing' because BTP's are the only periphery curve steepening like this. My fundamental view, which permeates the trade, is purely psychological: I believe most traders are still scarred from recent 'surprises' (DJT + Brexit + terrorism + all the other surprising stuff in the world). As a result, the market has been consistently overestimating the likelihood of risk-off events. This is an even more extreme version of 'buy the rumor, sell the news': there's so much 'buying the rumor' that you're probably well advised to sell both the rumor and the news! That's basically what this trade is: if you take on an Italian 2s5s flattener, you are betting, not necessarily that the Italian election will turn out just fine, but basically that the market is too stressed relative to what is likely to happen in the real world.

I'll save the philosophizing for another time, but this trade gets at the fundamental difference between risk and uncertainty. This high carry/rolldown, and tactically very cheap trade, is effectively profiting from other participants' discomfort with ambiguity. It's not that there aren't risks associated with Italian politics – it's that even in the worst case scenario (i.e. far left of risk distribution), the curve should flatten relative to now, since the steepness reflects uncertainty rather than dispassionate evaluation of probabilities. So like most successful trades, it's basically just profiting from the emotional immaturity of other traders (sorry if you're reading this and you have a steepener on... it's nothing personal, and further, I'm often wrong!).

Of course when one considers any sort of EZ rates trade, the core vs. periphery debt distinction must be top of mind. This is very much a periphery trade, so bear in mind all of the risk characteristics associated with that (it's like the 'Wild West' of low-yld DM sovereign rates trading!). But because so much action in rates markets is monetary policy driven in this day and age (esp. as ECB continues to hoover up all the bonds it can get its hands on), we must take into consideration both price action in core debt (which represents more of a risk-free EUR-denominated term structure), and ECB machinations. Here is the Italian curve against the German curve, with the same times (1yr ago vs. today):

The part of the above chart to pay attention to is the 'change bar' stuff towards the bottom. Obviously, German yield levels are lower across the term structure than BTPs but you can still see the similar movements occurring. As I'll describe in a moment in my convexity discussion, part of this has to do with the 'vol selling' narrative also making an appearance in the rates market.

But let's consider why a flattener is an attractive trade at these yield levels. Firstly, there are high component returns from both carry and rolldown when you go long this flattener against such an intermediately steep curve. Can't argue with that: 70.3 is pretty juicy for a 5y.

I'm still not entirely clear on why the intermediate BTP yields cheapened so much, but BNP's working hypothesis is that it's because "investors used the BTP future as a hedge against eurozone sustainability risk." This is consistent with my overarching 'risk vs. uncertainty' hypothesis.

There are two attractive aspects of this as a speculative play. Typically, going into an election where people are a bit spooked (as the community of macro tourists instinctively is, after Brexit + DJT), the curve steepens, and (regardless of what happens!) flattens afterwards. So there's a point in the 'for' column, derived from the risk/uncertainty argument.

Next there's the convexity consideration, which is important, and in this instance enigmatic to me. I don't presently have a conclusion on it, but I can provide some color. Convexity, of course, is extremely important when trading the longer end of the curve. It is essential to have at least an understanding, and preferably an outlook, on the pricing of vol. If this dynamic is unfamiliar to you, definitely look into it, but the gist of it is as follows: Convexity only makes a noticeable difference in returns when the moves in market yields are relatively large, and that by definition is when volatility is high. So, assuming a neutral duration outlook, traders still bid long-dated yields up or down depending on their vol outlook. If, for example, you are bullish on rates vol, you could build a position that is net neutral on duration, where you are beta-weighted long the long-end and short the short-end, so that regardless of the direction of yield changes, your long appreciates more than your short, because of the positive association between maturity and convexity (this only works, of course, if the realized magnitude of yield changes exceeds the market's forward pricing of rate vol, as implied by some inferred estimate of convexity bias. Go ask a quant if you want more... that's sort of the best I can do). This hypothetical long convexity bet would be a flattener trade, just like the one I am considering in this piece.

Going off of this convexity discussion, I would tentatively conclude that the market is betting on little movement in Italian yields (i.e. the market has on net been selling the intermediate/long end and bidding on the short end, which results in net short convexity trade. Not sure what implied positioning would be on Italian yields, but if you want to look into it, you first look at market positioning on core 'risk free' rates, i.e. bunds, and then look at positioning on the Bund-10yrBTP basis, because EZ periphery sovereigns trade as a sum of those two components, which are relatively independent of one another). I don't know if this is a conclusion I would trade against, because I can't find a good reason to agree or disagree with the market there. So, neutral on convexity. Sorry I can't provide more clarity. Please reach out if you have thoughts, corrections, etc.

To recap, the (hypothetical... after all this is not trade advice. Don't actually do this. Do your homework.) trade is an Italian 2s5s flattener. While a market for the rates options does not exist (boo-hoo, no way to take advantage of cheap impvol today), there is a pretty liquid market for 2y BTP and 10y BTP futs. So executing in futs obviously precludes possibility of 2s5s trade, because there aren't futs in 5y sector. So your carry/rolldown is less gorgeous, but she'll still get the job done. But pick your poison, spot or futs. The rolldown is more attractive in 2s5s, so a financed spot flattener is probably the best risk:reward here. That is all. Like I said, not a settled or persuasive case, just a series of connected thoughts.

HOPEFULLY WE WILL LEARN SOMETHING THIS MONTH

Look, prices have sort of just been confusedly searching for direction since the beginning of the year. Rates, despite all the melodrama, are flat. There ain't much more to it. Yeah, there've been equity flows, a couple of EM currencies have gotten hammered off of idiosyncratic risk, then remade a lot of the losses. There have been opportunities for tactical wins, but in terms of getting an 'overarching narrative' right, that's sort of been a loser's game so far, because, well, there hasn't been a narrative really, so everyone has been wrong! Unless of course you nailed European equities currency-unhedged ;) Just kidding, sort of...

'Reflation' was the big thing a while ago (remember that?!), but YTD inflation breakevens have been middling, with the exception of the UK, where cost inflation has been high and is expected to continue:

But could that perhaps change in June? There's stuff going on (central banks, elections, blah blah blah), but I don't have a stance. My marginal inclination is that participants will prefer to cling to ambiguity, no matter what happens during several crucial June events. This is my belief because there is a special attraction to ambiguity: when the market fails to collectively latch on to a singular, defined narrative, traders can imprint whatever story they want on data prints, price action, etc. If things are moving, but without a cohesive narrative or direction, everyone can talk themselves into feeling like a master of the universe (and don't kid yourself, it's human nature to subconsciously massage information in our heads until cognitive dissonance disappears, and we feel pretty happy with ourselves). So, in short, there is a high bar in my opinion for a consistent narrative to develop across global markets. (I have written about Trump stuff before, but for what it's worth, I don't think even a Trump impeachment or similar political earthquake would set off much of a new narrative, unless coupled with seriously hawkish CB action. If those two things were to both happen, we'll talk.)

NOT WMD'S, BUT MORE LIKE URANIUM

As I was brushing up on some CDS stuff this morning, I was reminded of the youth of many derivatives contracts. Now I'm not talking here about OTC entropy swaps (those aren't as fancy as they sound, but boy do they sure sound fancy!) or anything whacky, but pretty straightforward products like CDS and vanilla rate swaps. Here's Dominic O'Kane in Frank Fabozzi's seminal The Handbook of Fixed Income Securities:

By the mid 1990s the concept of a CDS contract had been established. However, the market lacked standardized legal definitions for the credit events that trigger the contract, and for the protected debt obligations...

... The significant growth phase of the CDS market therefore only started following the publication of the first Credit Derivative Definitions by the International Swaps and Dealers Association (ISDA) in 1999. 

And the rest was history. I won't mention the numbers on notional outstanding, because, while the market is definitely big, talking about notional numbers always misleads our puny human brains, for obvious reasons. Dominic goes on to provide more fascinating color, but I encourage you to crack open the book for more.

What made an impression on me, was just the reminder of how youthful this massive part of the securities universe is. It is difficult to imagine what a dealer desk would look like today if all of these recently created products ceased to exist, yet that was the state of affairs up until quite recently.

Warren Buffett's "weapons of mass destruction" quote about derivatives got a lot of play in the financial and mainstream press when he first brought it up, but it strikes me (and I suspect he would agree) as a dangerous oversimplification.

The way I think about derivatives, is not as WMD's, but as uranium. This is to say, it could go very well, or very poorly. It's less about the nature of the material (the specifications of a given derivative instrument), but about the humans using it (the context in which a derivative is being used: speculation, hedge, relative value, etc). Uranium can be used to fuel an extremely effective and clean power source. It can also be used to literally make the earth inhospitable to human life several times over.

There's even a further parallel to be made between uranium and derivatives products. They are both incredibly new, relative to humanity, and certainly relative to earth itself. Thus, they have yet to prove themselves net good or net bad. And as just mentioned, whether they turn out to nurture or destroy humanity is up to us. So, no, they are not themselves weapons of mass destruction. They are uranium, and can be turned into WMD's, or into clean energy: it's up to us. But don't argue against mechanisms of risk transfer/sharing, argue against senseless and idiotic assumption of too much risk, and too much concentration of risk. Derivatives = Uranium.