The sharp rise in inflation that characterized 2021 and the first part of 2022 led the main central banks to a sudden change in monetary policy stance in the direction of a sharp reduction in liquidity in the system (end of QE for Fed and ECB) together with a rise in interest rates. The effect on the financial markets was a negative performance for the main asset classes that went from pricing a scenario of economic expansion to one of risk of recession. Furthermore, in Italy, in recent months, we have experienced the fall of the Draghi government, which, bringing political uncertainty (new elections have been called for 25th of September 2022), is to be considered a potential additional specific risk factor that could have further negative effects, in addition to the complicated global macroeconomic scenario, on italian financial assets such as BTP, for the bond category (government bonds) and the FTSEMIB (the italian stock index) for that of equity.
In this article, on the occasion of the upcoming italian electoral deadline, I propose to do a brief analysis on the trend of these two italian financial assets (BTP and FTSEMIB) over the last few years to better understand their behavior within the economic phases that have characterized the global macroeconomic scenario.
With regard to the asset class of government bonds in general, we have already dealt with (in other articles) the issue relating to which can be considered risk free and, although we know that nothing is to be considered as such, however, we usually tend to identify with this appellation, in the euro area, the german government bonds (Bund) and, in the dollar area, the US Treasury bonds.
With regard to italian government bonds (BTP), during the years of 2011 and 2012 we experienced first-hand the effects of the sovereign debt crisis and precisely on that occasion we understood the difference between “safe” or ” risk free” assets like the german Bund and those not, like our BTPs. It was exactly in that period that the “BTP Bund spread” measure began to be used to identify the difference in risk between the core, the virtuous Germany, and the periphery, which we generally identify here with Italy (remember that our country is the third for economic importance in the euro area with an important public debt and used by financial operators at a global level to express their view on the european area in the different phases of the economic cycle). In fact, the market buys BTPs in relative against Bund (the spread tightens) when it thinks that the economic / political conditions relating to the european periphery are improving. Conversely, the market sells BTPs and buys Bunds (the spread widens) when it perceives that Italy risk (or more generally the periphery risk / fragmentation risk) is or should increase in the near future. It is this behavior that leads us to consider the BTP more similar to a “spread asset“, rather than a risk free asset (it incorporates a sort of “credit risk“). This feature leads our sovereign debt to have a “factor in common“, conveys a sort of “risk premium” expressed by the BTP Bund differential, with the italian stock market, which, as is the case for global stock markets, is characterized by the fact to have its own risk premium (equity risk premium). This is why the BTP should be considered as a “risk premium asset” (even if the FTSEMIB, being an equity index, is fundamentally driven by the trend and riskiness of the profits it generates and by this nature reflects a higher risk profile) and is the reason why its trend over time correlates well (R2 @ 50, 11 yrs) with the italian stock market as can be seen from the chart I propose below.
FTSEMIB Index vs 10yrs BTP Bund spread (in bps, inverted)
The figure shows the trend over the last eleven years between the italian stock market series (FTSEMIB Index), on the left scale in blue and the 10-year BTP Bund spread (in basis points, inverted), on the right scale in yellow. From the chart you can see some periods in which the two series are very correlated and others in which the correlation “seems to decrease“.
Let’s try to understand why.
We can basically identify two phases of “low correlation” which we propose again in the graph below highlighted by two red circles and arrows:
FTSEMIB Index vs 10yrs BTP Bund spread (in bps, inverted)
The first we call US Midcycle slowdown & CNY devaluation identifies the phase that went from the second half of 2015 to the first part of 2016 (about eight months). In fact, the summer of 2015 is remembered for the intervention of the PBOC (People Bank of China – the chinese central bank-) on the renminbi aimed at “realigning” the chinese currency to the dollar, with the consequent flight of capital, the negative effects this had on emerging markets (bonds, stocks and currencies) and the contagion on developed ones (economic slowdown in the US with negative effects on both equity and credit). Global financial markets fell in the second half of 2015 and then double-digit between january and february 2016. On the other hand, however, core rates (Treasury and Bund) fell (had the function of hedge) and the US $ strengthened against the main currencies. In short, the classic “risk off” phase.
The second that we call Covid19 Recession identifies the period in which the pandemic affected the whole world creating a strong economic recession and the generalized “risk off” phase of the financial markets characterized practically all the main asset classes.
These two phases are united by the fact that in both periods the ECB had QE in place (strong purchases of European government bonds – among which, in good proportion, were the italian ones -). This program was interrupted in 2019 (with the announcement of the then president of the European central bank Mario Draghi in June 2018) and then resumed in 2020, along with other support measures, due to the pandemic (Codiv19).
We believe it probable that the strong purchases of BTPs in the ECB program were such as to “artificially contain” the decline in their price (by “artificial” I mean not to occur due to natural demand for the asset class or due to economic growth prospects in improvement and / or reduction of political risk) and create resilience with respect to the Italian equity index (FTSEMIB Index) which, inevitably, not subject to “massive coordinated purchases“, could only follow its nature as a risk asset (to honor of the truth, as I wrote before, the italian equity index is driven by additional factors compared to BTPs, such as, for example, the prospects of the profits of the companies that compose it) and has therefore seen its prices fall in line with the risk off that characterized the main risky assets in the two phases of the global down turn. To confirm all this, in the most intense period of the pandemic (december 2019 / november 2020) the correlation dropped to 32% (R2 @32, 1y). A level that could have been lower but “tainted on the upside” by the fact that the ECB QE was not present in the first months of the analysis and was “reactivated in the running” during the pandemic. While, in the eight months ranging from the second half of 2015 to the first months of 2016 (at that time the ECB QE was up & running) the correlation even drops to 1% (R2@1, 8m).
This hypothesis (artificiality in the behavior of the BTP Bund spread in the periods affected by the QE program of the ECB) is satisfied when we analyze the periods in which the ECB QE was not present as can be seen from the graph that I propose below in the two phases highlighted by circles and blue arrows.
FTSEMIB Index vs 10yrs BTP Bund spread (in bps, inverted)
The first one, which we call Draghi: whatever it takes begins with the now famous sentence by Mario Draghi (july 2012) which restores confidence in the fate of the eurozone after a period of extreme difficulty and from there to a series of economic measures that reinvigorate growth giving perspective and then follows a global subsequent strong risk on phase. The correlation between the BTP Bund spread and the Italian stock market rises to about 80% in the three years from 2012 to 2014 (R2 @ 80.3yrs).
The second one that we define 2018/2019 Risk off / on & Italian Election includes the end of 2018 which is characterized by the weak US economic growth and by a hawkish Fed (remember its president Powell who contributes negatively with the phrase “autopilot” in december 2018 referring to the reduction of the Fed balance sheet), the end of the ECB QE (december 2018) and, as regards the issues of our country, the italian elections with the victory of the Five Star Movement (considered by international operators an additional specific Italian risk): all factors that created a strong risk off phase. The 2019, on the other hand, is remembered for a strong global risk-on phase which was triggered by the much more dovish change in monetary policy stance by the Fed completely unexpected by the financial markets. In these two phases (risk off and risk on) ranging from september 2018 to the end of 2019, the correlation between BTP Bund spread and the italian stock market rises to 70% (R2@70, 1.3yrs).
The analysis of these four phases (the two with the red circles and the two with the blue ones) lead us to conclude that in the absence of the QE program (the two phases with blue circles) both financial assets (BTP, in the form of BTP Bund spread and the FTSEMIB) behave in a “natural way” according to their characteristics, as “risk premium assets“: they rise in the risk on phases and fall in the risk off phases. Conversely, in the presence of purchase programs (when the ECB QE is active) the two tend to reduce the correlation and diverge, particularly in the risk off phases. In fact, on those occasions, international operators not being able to use the BTP asset (when QE is active), to express their views on the economic and political prospects of the area, tend to “download the country risk” on the italian stock market creating an additional negative effect on its prices.
All this leads to today with the FTSEMIB in the area of 22,000 points and the 10 yrs BTP Bund spread at around 230 bps. As we said at the beginning, the scenario we are experiencing this year is that of a risk off phase driven by fears of an imminent global recession, by the reduction of liquidity in the system (the ECB has no QE program in place and is raising interest rates) and, as far as Italy is concerned, we are about a month away from the elections (potential italian specific risk). These three factors in the field are determining the trend of our two assets in line with the phases previously highlighted by the blue circles (those characterized by not having an active QE program): the correlation between BTP Bund spread and stock market has risen to 72% (R2@ 72, 1yr), as can be seen on the right in the graph below highlighted by a circle and a blue arrow.
FTSEMIB Index vs 10yrs BTP Bund spread (in bps, invertito)
What to expect for the near future?
The scenario is complex, there are global (liquidity reduction and recessive risk) and specific (italian elections) factors that are conditioning and could continue to weigh on italian assets (BTP and FTSEMIB). The ECB has in its drawer the TPI (Transmission Protection Instrument), an instrument that on the one hand, if activated, could potentially change the fate of the BTP and make it diverge from the FTSEMIB, and therefore reduce any risk of fragmentation on the other hand, however, its use could be linked to the outcome of the italian elections and the winners’ programs. With the difficulty of depicting an uncertain scenario such as the one facing us, we remember the nature of the two instruments analyzed and their characteristics (risk premium assets) in order to be able to manage them well when events evolve.