As vigilantes go they're hardly Charles Bronson, but still .......

Monday 21st November 2016

As vigilantes go they're hardly Charles Bronson, but still .......

ref :- "Currency Vigilantes Ready to Strike Again as Italian Vote Looms" , Bloomberg Markets

We're staying with Italy and its referendum, largely because the weekend saw the publication of the last polls before the "poll blackout" imposed for the final two weeks before the date of the vote, December 4th. It's likely that such bans were designed to help protect the integrity of the democratic process rather than to just make life difficult for those unscrupulous speculators gambling on the the result, but it's looking like an increasingly sensible idea. The dismal recent record of polls on both sides of the Atlantic suggests that a blanket ban would be doing us all a favour. 

Whatever the case, the four final surveys confirmed what earlier ones had been saying ..... essentially, a lead for the "No" vote but with many still undecided. You'll remember what we were saying last week about what a rejection of PM Renzi's proposals COULD mean ? A Renzi resignation, electoral success for the 5 Star populist opposition party committed to popular vote on Euro membership etc etc ... ? So how are the so-called vigilantes positioning themselves to take advantage of things should events follow that very dangerous path ?

In market parlance, "vigilante" has been a term most often used in connection with the bond markets. Bond vigilantes imposed fiscal discipline on borrowers thought to be lacking appropriate rigour by forcing up the cost of their debt. Its not as though they were acting out of altruism of course  --  self-interest is always the motivation  --  but they did in effect "police" the more wayward borrowers. The thing with the upcoming referendum though is that should the result be a rejection of the proposed reforms, Italian bonds are unlikely to feel the full market backlash. To some degree they will be protected by the ECB's enormous bond-purchasing proramme (QE), in another example of what used to be considered normal market dynamics being warped by the ultra-loose monetary policies of central banks.

If you accept that QE has changed the responsive nature of bond markets to such a development, including constraining the sharp widening of yield spreads between Italian (in this case) and other debt, and is also distorting equity markets, then the foreign exchange market is the one place where vigilantes can still do their thing. Traders are positioning themselves for the vote going against PM Renzi by selling the euro rather than by selling Italian bonds. As David Bloom of HSBC puts it, in FX markets politics is the new economics. 

Many cite Brexit as the best example of how , when political risk becomes fact, it's the currency that suffers rather than bond markets. Perceptions about the potential damage to UK Ltd by Brexit saw sterling fall by about 18%, while UK government bonds headed sharply in the other direction as investors indulged in a flight-to-quality.

Selling the euro in advance of the referendum also chimes pretty well with the other great political event of the time ..... actually, of this or any other time. The Trump win heralds expansionary fiscal and tighter monetary policy in the States whilst the European Central Bank is still threatening extensions/expansions to its own easy policy. The diverging path for interest rates between the States and Europe supports a long USD / short EURO position even before you consider Italy's issues and what they could mean for the EU as a whole.

Since the US election on Nov 8th, the euro has dropped about 3.6% against the dollar. Italian bonds are weaker too of course, by about 2.3% after being dragged lower wi5th bond markets the world over by US Treasuries and their reaction to the likely inflationary effects of Mr Trump's programme. But if you're looking to profit from a "no" vote in the referndum, the suggestion here is that there'll be a lot more mileage in selling the euro than doing the same in Italian bonds. Instinctively, you feel both should suffer but the euro does not have the backstop of ECB support that QE supplies to bonds.

It's just one point of view of course, but the thinking seems sound enough. It assumes a "no" vote in the referendum, and Mr Renzi will have to defy the polls if he's to get these measures through ..... but who knows, looking at the recent form of political polls, that might be in his favour.

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