Palisade Research - Tue, May 30, 2018

Blowing Up: The Italian Debt Crisis, the Experts That Missed it - And What's Next

image of a businessman standing on falling dominos

With the crisis unfolding in Italy, I can't help but remember the lessons from the underrated book - Fat Tail by Ian Bremmer.

This book is an excellent read and explains how political risks can lead to severe economic and social risks.

But first, what exactly is risk? I sum it up into three things. . .

1. Probability - how likely is the risk to happen?

2. Impact - if it does happen, how big will the loss be?

3. Consequences - what is exposed to the impact, what are the second order effects (basically what's the chain reaction from it)

Once we know the three parts to risk, we can start to understand how it works and what will be affected.

Bremmer's book shows that throughout history, the government's political risks - caused by their near-sighted policies - can lead to unknown monumental shifts and catastrophes. . .

"What do we mean by a 'fat tail'? Fat tails are the unexpectedly thick 'tails' - or bulges - that we find on the tail ends of distribution curves that measure risks and their impact. They represent the risk that a particular event will occur that appears so catastrophically damaging, unlikely to happen, and difficult to predict, that many of us choose to simply ignore it... - Ian Bremmer, Fat Tail.

For instance, in the mid-1700's, England's King George was facing severe financial problems. Because of the costly French and Indian War, the British Empire was deep in debt. They needed to generate revenue - and quickly.

The Empire's solution was to pass a series of new taxes designed to profit from the colonies in the 1760's - the infamous 'stamp act' and 'tea tax'. But these were wildly unpopular, and led to the colonies fighting for their independence in the American Revolution.

To summarize: with simply trying to raise revenue and pay off their debts by placing relatively small taxes on the colonies, the British Empire ended up triggering a revolution that left them embarrassed, weakened, and poorer.

Today, the political risks in Italy have turned their financial world upside down.

And in the mind of herd investors and financial 'experts', owning Italian bonds were safe and low risk - that is, until it wasn't.

Look at the spread between Italian 2-year bonds and their German counterparts - essentially overnight Italian bonds 'blew up'. . .

line chart of 2-year yield spreads between German and Italian bonds, since 2013

From the perspective of the bond market - with how fast they re-priced everything, triggering massive losses - they clearly didn't see any of the risks.

I can hear them now. . .

"No one could have seen this coming."

"Look, it's not like anyone else was expecting this - it was a fluke."

"I'm sorry that we lost all your money, but everyone got burned from this - it wasn't just our fund alone."

But - were things really this unexpected? What about a week before Puerto Rico defaulted in 2016 or Greece in 2010? People were buying their bonds up until the final hours.

Studying the blow up in Italian bonds - I can't help but rope in the ideas from another great thinker.

Nassim Taleb and his 'Turkey on Thanksgiving' Paradox. . .

Imagine a nice plump turkey on a farm.

The turkey's taken care of and is given food daily. It lives in a nice open-range pen and freely trots around.

As time goes on, the turkey becomes used to how things are - its daily routine - and It feels safe and secure eating its meals everyday at noon.

If you were to graph this, you would see an upwards sloping line. Investors and economic 'experts' can use fancy math and collect past data to make forecasts over the next five years - feeling confident things will continue.

That is - until it's Thanksgiving Day and the farmer takes the turkey out back and cuts its head off. . .

line chart of Turkey's rising well-being and confidence over time plummets around thanksgiving day

The irony was that with each passing day, the turkey felt his risks decreasing as it became used to the daily routine. But, in reality, it's risks are actually increasing as each day goes by.

So, looking back, the turkey was at peak well-being and confidence just as the risk was at its highest.

The takeaway from all this is: don't ever be the turkey. . .

In regards to Italy - what I'm asking now is: "who're all the 'turkeys' holding onto - and are exposed to - Italian debt?"

We know that when bond yields go up, bond prices go down. And whoever owns all these depreciating bonds - mostly owned by banks - will suffer.

Problem is - the opportunity's gone now. The bonds already crashed. Sure, they can fall further - but there isn't much left to squeeze out without much higher risks.

To make huge gains, you need to have your positions selected well-ahead of time. Then once things unfold, you sell at a huge profit.

Now the real question is: "what's the contagion from this Italian debt crisis?"

One potential opportunity right now is watching the Federal Reserve and what they do in June. . .

The U.S. yield curve is now at its flattest point since the end of 2007. Investors rushing into 'safe' 10-year Bonds because of Italy over the last couple days has killed the 'bond bears' and pushed yields far down.

line chart of 10-year minus 2-year treasuries constant maturities as a yield percentage, since 1975

At this rate, the Fed risks inverting the yield curve if they hike again in June.

And as I've written about before - an inverted yield curve has preceded the last 9-out-of-10 recessions in the United States. . .

The Fed's own James Bullard said earlier today. . . "Holding off on further rate increases... would help improve market-based measures of inflation expectations and make the Fed's commitment to meeting its inflation target more credible. It would also lower risks that short term interest rates might rise above long-term ones, an 'inversion' of the yield curve that has often preceded a recession."

But what happened to the 'nice yield slope' Mr. Bullard saw only 27 days ago? Now he's worried about preventing inversion? Imagine that.

The market isn't expecting the Fed to hold off on hiking in June. The financial media is touting it as if it's a sure thing.

They could be in for a big surprise - just like the poor turkey. . . publishes interesting contributor articles in addition to its own content. We have not verified any of the above details.

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