Stewart Cowley: how to solve Italy's bond market mystery

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I worked in a pub in the North East of England in the 1970s.

One day at 11.30am, as I was clearing glasses away from a table, I noticed that the four people nursing their second pint of the day were struggling with the Sun crossword. 'Big furry thing, lives in Africa, eats antelopes and goes RRRRRRrr!!! Four letters, begins with L ends in N,' they mused aloud, over and over again. The tension was palpable and although it wasn’t my place I couldn’t but help say, 'Lion…?'

As one, eight eyes swivelled towards me and with a look of awe that has never been reproduced ever in my life again, one of them exclaimed, 'And whose clever little boy are YOU!!!!!' The lesson that I was taught at that instant was that saying the absolutely obvious can, sometimes, come as a shock.

Italian bond mystery

And with that, I turn my attention to Italy.

I have to confess the Italian bond market has been a mystery for about six months now. Since the high point in yields in last year of some 6.5% down to today’s 4.25%.

Non-annualised returns have been some 16% for ten-year maturity bonds over that time period so it has been a significant opportunity lost.

True, the backstop created by the European Central Bank in September should have given us a clue that things were OK but even that safety net was so full of caveats that it has, in all reality, the value of an HMV gift voucher.

Anyway, the rally had started long before that. Clearly, something has been going on behind the scenes that wasn’t obvious to daily observers.

We can now say what that was; banks awash with cash started buying Italian government bonds again. It seems like an obvious thing and we had some inkling of it but the sheer scale of it and its sustainability is what concerns us.

On an annualised basis, Italian banks are buying or recycling some €100 billion a year back into the Italian bond market. ‘Other’ big countries in Europe, like Germany, France, Spain etc..., are collectively doing the same. In other words, Italy has been relying on the kindness of strangers as much as it does on the benevolence of its own citizens to fund its debt issuance program. Any slip in that process and yields should start to rise again.

And it can happen. Just on the basis of history, it is doubtful that Italy and its European allies can keep on buying at the current rate of accumulation.

The post-July 2012 period was an unusually rapid period of buying for the ‘Others’ so that prop should be kicked from under the market going forwards.

A ponzi scheme

Also, domestically, the economic situation is continuing to deteriorate. Unemployment is over 11% but more to the point Non-Performing Loans for households and non-financial corporations are rising at a rapid rate (6.4% and 9.3% respectively in 2012). 

For individuals and companies who have been using Italian government bonds for cash management you understand why they might divert some of their funds from the issuance program and towards debt reduction.

At a national level Italy runs a primary surplus. In other words its real problem is the interest payments that it has to fund annually which is what creates its 4% of GDP deficit.

This is the massive Ponzi scheme that Italian national finances runs on – when you are borrowing to pay the interest on your debts you are in real trouble.

But in the face of citizens increasingly digging into savings in order to sustain their lifestyle, the likelihood is that this prop that supports the Italian bond market will be taken away. You don’t have to be too clever to work out what that would do to Italian bond yields going forwards.

And don’t forget we have not even mentioned politics yet.

Cowley manages the Old Mutual Global Strategic Bond fund. In the three years to 21 January the fund has returned 23.7% versus a 14.3% rise in the benchmark.