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 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!).