Daily Archives: July 13, 2012

James Mackintosh

Everyone knows how the dominoes will fall in Europe: Spain, then Italy, then struggling France, stuck with the biggest of big governments, a Socialist president and a population that thinks the work ethic is a type of chocolate biscuit.

Hedge funds spent much of last year warning that France might even leapfrog Italy in the contagion queue, while betting against French government debt. So it must come as a bit of a surprise that the French 2-year bond now yields less than half that of the US, and is below the UK.

French 2 year yield

French 2 year bond yield (Source: Bloomberg)

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James Mackintosh

Commentators have been having fun at the expense of the credit rating agencies recently, pointing out that after their downgrades markets have been upgrading various securities. It’s tempting to think the same after Moody’s two-notch downgrade of Italy today, with the euro up very slightly at $1.22 (although still close to a two-year low), while the 6 basis point rise in yield on Italy’s 10-year bonds is hardly dramatic by recent standards.

But that is to ignore the place where the downgrade really has power: Italian inflation-linked bonds. Moody’s actions will mean that Italian linkers fall out of the main Barclays index, which has stricter conditions than the main indices for nominal bonds.

Billions of euros of tracker funds will now have to sell Italian linkers, one of the biggest linker markets, eliminating a big source of demand – and showing what could happen if two of the three big rating agencies downgrade Italy to junk, knocking it out of the nominal indices. Read more