Bond vigilantes beware: bets against China and Italy are a fool’s errand
If debt markets come under severe strain, vigilantes may ramp up their bearish bets against countries they perceive as vulnerable to tighter financial conditions
Are the “bond vigilantes” about to come out of hibernation?
Ever since the global financial crisis erupted, forcing the world’s leading central banks to shore up financial markets by introducing ultra-loose monetary policies, bond investors who specialise in punishing governments and companies for racking up excessive debts and stoking inflation have been driven out of business.
Central banks’ aggressive programmes of quantitative easing have pushed government bond yields down to historically low levels, distorting asset prices and divesting the vigilantes of their main weapon: a bond buyers’ strike which drives up yields and forces borrowers to mend their ways.
Yet over the past several months, and especially since the beginning of this year, market developments finally appear to be moving in the vigilantes’ favour.
Last Friday, the yield on the benchmark 10-year Treasury bond rose above 2.8 per cent, its highest level in four years, following the publication of data showing that US wages last month grew at their quickest pace since 2009. The US budget deficit, moreover, is expected to increase to 5.7 per cent of GDP next year – its highest level since the early 1980s – following the enactment of a massive tax cut in December. This is fuelling concerns that inflationary pressures are building at a fast enough pace to force the Federal Reserve to raise interest rates more aggressively than anticipated.
If global debt markets come under severe strain – German 10-year bond yields have also risen sharply – the vigilantes may feel emboldened to ramp up their bearish bets against countries which they perceive as being particularly vulnerable to a significant tightening in financial conditions.
Among the world’s major economies, two in particular have long been the target of the short sellers: China and Italy.
The rationale for bearish wagers against China’s economy is well known: since the financial crisis, China has been on a massive borrowing binge in which total debt has rapidly quadrupled to US$28 trillion, up from 140 per cent to more than 260 per cent of GDP, according to the Bank for International Settlements. Last year, the International Monetary Fund warned that “international experience suggests that China’s credit trajectory is dangerous, with increasing risks of a disruptive adjustment.”
Prominent China bears, including Kynikos Associates, the hedge fund run by James Chanos, and Hayman Capital, another fund, headed by Kyle Bass, are convinced that China’s credit boom will turn to bust and have been trying to “short” China for many years, adamant that mounting tensions between deleveraging and growth will ultimately prove unmanageable.
Yet the short China trade has yet to pay off – and has so far proved to be a “widow-maker” akin to the failed bets against Japan’s heavily indebted economy.
State intervention in China’s markets and economy makes it extremely difficult for foreign investors to gain the necessary foothold to exert influence over asset prices. China bears underestimated the lengths to which policymakers are willing to go – and the huge financial resources at their disposal – to stabilise markets during periods of turmoil, particularly when it comes to the yuan which is now at its strongest level versus the dollar since the surprise devaluation in August 2015. Foreigners, moreover, hold only 2 per cent of China’s local bonds, while retail investors account for as much as 80 per cent of the trading volume in China’s stock market, according to Bloomberg.
Italy, on the other hand, is more vulnerable as a result of being a much more open economy.
With Europe’s second highest level of public debt as a share of GDP after Greece, a banking sector weighed down by non-performing loans and a high-stakes parliamentary election next month in which populist and anti-euro parties are expected to perform well, Italy is the euro-zone country most at risk from the removal of stimulus by the European Central Bank.
Last week, data from Bloomberg revealed that Bridgewater, the world’s largest hedge fund, has tripled its bearish bets against Italian financial firms, including Intesa Sanpaolo, Italy’s second-biggest bank, ahead of the election. Moreover, unlike China, nearly a third of Italy’s domestic bonds are held by foreigners.
Yet as the acute phase of the euro-zone crisis revealed, betting against Italy means betting against the euro zone, and in particular the European Central Bank.
Italy is Europe’s third-largest economy and one of the world’s most actively traded government bond markets, making it “too big to fail”. While the end of quantitative easing is undoubtedly going to put Italian debt under strain, the ECB will not allow any further turmoil in Italy to seriously endanger the rest of the euro zone. Investors know this, which is one of the reasons why Italy was able to attract more than €30 billion of orders for the sale of a 20-year bond earlier this year.
Pressure on bond markets may well intensify over the coming days and weeks, but bearish wagers against China and Italy are a fool’s errand.
Nicholas Spiro is a partner at Lauressa Advisory