I don’t know if you’re aware of this or not, but somewhere, buried beneath $15 trillion-ish in central bank liquidity and hiding under the distortions that liquidity has created by effectively forcing investors to knowingly misallocate mountains of capital, are actual markets.
To be sure, price discovery (where that entails the participation of price sensitive investors) hasn’t really a been a thing for the better part of the last decade.
In one way or another, all the bids are price insensitive these days, whether by definition (e.g., central banks), by choice (e.g., Norway’s SWF) or else by accident (e.g., retail investors not understanding that ETFs don’t generally contribute to price discovery). Everyone else is effectively forced to adopt a similarly “long hair don’t care”-ish strategy because what else are you going to?
When everything is indiscriminately bid to infinity and that dynamic traces its roots to policymakers with printing presses, well then you either harvest yourself some carry alongside everyone else or you go the fuck out of business. It converges on one trade. It’s a binary option: you either short vol. (explicitly or implicitly) or else you take it upon yourself to shriek “the emperor has no clothes!” and risk nobody being willing/brave enough to go along with you.
It is questionable whether markets can ever be completely reemancipated or even whether reemancipation is something people want.
That said, there are times when price discovery does its best impression of the villain at the end of a slasher flick – everyone is standing around looking at what they think is a corpse and then, it suddenly sits upright and “grabs ’em by the (figurative) pussy”. In markets, this just means that on occasion, folks forget what they’re “supposed” to do (i.e., demonstrate a voracious appetite for any semblance of yield) and start demanding compensation to take risk.
There’s a solid argument to be made that nowhere has price discovery been summarily relegated to the dustbin of history more than European credit markets, where the combination of PSPP driving everyone down the quality ladder (i.e., creating demand) and CSPP representing an ongoing, price insensitive bid for € IG (i.e., creating a dearth of supply) has left everything priced to absolute perfection. Last year, this started to manifest itself in European junk trading inside of U.S. Treasurys. As of last August (and I’m not sure how this has evolved), some €23 billion of Italian BBs were yielding less than equivalent-maturity US government bonds.
“Whatever it takes” indeed. And also “as long as it takes”. And also “come hell or high populism”.
So, despite multiple brushes with EMU breakup risk and a series of close encounters of the populist kind, yields on European sovereigns have remained suppressed, periphery spreads have been beaten back every time they try to blow out and the € credit market is a freakish farce.
One manifestation of this was the steady grind lower in the BTP-bund spread in and around the Italian elections. Hilariously, periphery debt acted a bit like a “safe haven” during February and March. The elections in Italy were of course inconclusive and after a month of gerrymandering and horse-trading, Five Star and League finally got around to trying to form a government and if you know anything about Five Star and League, you know that is not a market-friendly outcome.
And so, this week, the “villain” that is price discovery decided to “come back to life, for one last scare” (to quote the original Scream, a movie which came out when some of Wall Street’s current occupants were literally still in diapers).
Here’s what Italian bonds have done as the worst case populist scenario materialized this week:
And more to the point, here’s the BTP-bund spread:
Now there are two ways to look at this, one is based on reality and the other is based on conspiracy theories.
In reality, this is the market attempting some price discovery in light of the fact that there are serious concerns about fiscal sustainability under a Five Star- League government. Those concerns were underscored earlier this week when HuffPo got ahold of a draft “plan” which suggested the new government might seek an absurd €250 billion ECB write down.
In make-believe populist land though, this is a conspiracy of devils.
Here’s FT, from a piece out Thursday:
The leaders of Italy’s two leading populist parties took aim at global financial markets on Wednesday, accusing investors of trying to “blackmail” them by unloading Italian assets as they tried to form a new government.
“As soon as we have considered a Five Star/League government the anxiety has begun,” said Luigi Di Maio, Five Star’s leader. “I see a certain fear among the Eurocrats. But they don’t scare me.”
“They are trying to stop us with the usual blackmail of rising spreads, falling stock markets and European threats,” said Matteo Salvini, leader of the League. “This time change is coming, with more work and fewer illegals, more security and fewer taxes. #Italians first,” he wrote on his Facebook page.
Yes, “investors” are trying to “blackmail” Di Maio and Salvini by demanding more compensation for letting Italy borrow money now that Five Star and League are set to run the country.
In addition to being patently absurd, they’ve actually got this shit backwards. If there’s a “conspiracy” from market participants it’s one that’s explicitly designed to prevent spreads from blowing out in the periphery.
They can say all they want about the malicious “eurocrats”, but the bottom line is that Mario Draghi is quite literally printing €30 billion per month in order to keep the market from punishing fiscal profligacy and/or political uncertainty.
The real victims here won’t end up being Di Maio and Salvini, but rather anyone who attempts to short Italian bonds. Just ask the ECB’s Vitor Constancio who said this on Bloomberg TV:
We generally consider that markets have been reading our reaction function quite well.
The yields and the spreads have been contained until recently, there is this spike, we have to see how it will develop.
Yes, the market has been “reading [the ECB’s] reaction function quite well” where that means simply this:
I can tell you “how it will develop”. It will “develop” like the end of a slasher flick where price discovery comes back to life and tries to drive periphery spreads wider and Draghi pulls a Sidney…