zaterdag 6 oktober 2018

Financial markets are telling you something, but are you listening?


NICK HUBBLE


Dear Reader,
 
If an insurance company doesn’t offer flood insurance on your new home, you know you’ve got a problem.
 
Well, the insurance on Italian government debt is getting mighty expensive of late.
 
 
But there’s something else I want to show you.
 
You see, there’s a difference of opinion on the following question:
 
If Italy leaves the euro and goes back to the lira, does this constitute a default?
 
Having loans repaid with a different and devalued currency certainly would feel like a default for lenders.
 
But this is just the sort of thing an insurance company would use to weasel its way out of a claim.
 
Bloomber reports on the distinction by looking into Credit Default Swaps – the financial market version of an insurance contract:
 
The 2003 vintage of sovereign CDS contracts promises to pay back the face value of government bonds in the event of a debt restructuring.
 
The 2014 version offers additional protection against the risk that the defaulted bonds may also be converted into a currency other than the euro.
 
So the price difference between 2014 and 2003 CDSs with the same maturity shows the extra insurance premium investors are willing to pay for protection against a currency redenomination.
 
In other words, insurance contracts written in 2003 don’t cover you for flooding, but 2014 contracts do. The difference in price tells you the probability of a flood. Or, in this case, the probability of Italy leaving the euro.
 
Since 2017, the price difference has been growing. And since April it blew out.
 
This tells you investors are extremely worried about Italy leaving the euro.
 
Source: Bloomberg
 
To find out what that would do to British stocks, banks, and your net worth click here.

Best wishes, 
 
Nick Hubble
Editor, Capital & Conflict