Dear Italy, Be careful because when you are on fire ….gasoline looks like water!

Credit Suisse

It is another exciting day to be alive in the EU … Let’s see:

Yesterday the 5yr Italian Notes hit 7.7% with the yield curve going flat after that (I am predicting that the Italian yield curve will go inverted before the weekend) … and with their debt level being what it is (just north of 1 trillion) it surprises no one their debt load isn’t sustainable at 6.7% let alone 7.7%. Right now it sucks to be Italy.
Remember, it was yield levels just a little below these that forced Greece and Ireland to start sending up flares and calling in their “maydays” to the rest of the EU. With Italy’s economy being 3-4 times both Greece and Ireland, it will take some real money and a real plan happening really really fast to slow this freight train down. (Read …it’s not going to happen).
In mathematical textbooks written on risk management, one of the most common and persistent errors in the world of trading is the presumption of infinite liquidity at a single price (or sometimes at any price) during a time of crisis. That is because liquidity is the one asset whose supply disappears as its price rises. This is why we get volatility spikes during stock market sell-offs and large gaps on the charts when the unexpected happens. Another thing we see at times like this are a widening of the spreads between the Italian 10 yr notes, and the German 10 yr notes… which tells us to what degree the market values the risk of owning Italy over Germany …yesterday we saw that spread go to 125 bp and then pull back to about an even 100 bp. wow! That’s alot and it’s only going to get bigger.
There is nothing anyone can do to make this work. Italy is going to default and that’s all there is to it. Much better to just get it over with now than in 5-10 yrs, complete with all of the hand wringing and bailouts that would go with it). Or are you looking forward to 10 or 15 more years of on-again, off-again bailout funds, stability funds, EU votes, eurocrat politicking, yield spikes, shock and awe, volatility over nothing, and constant uncertainty? I’m sure not; it’s bad for business even for people who don’t even do business in Europe much less own any of this toxic debt.
I hope I don’t sound too cynical when I declare …”Well if there is nothing that can be done to make it work… then I may as well look for ways to profit from it not working”. So you weigh the various scenarios and then search for a spot in the market to exploit for fun and profit. What better place to start looking for those weak points, than in places where the government, and not the market, have been calling the shots…government meddling in the markets, where they insist on calling both the dance and the tune always creates exploitable opportuinities.
In other words in places like the “swissie”, who’s value was artificially pegged at 1.20 Euros back at the end of September. Whats happening now is classified for modeling purposes as a “Black Swan event” meaning an event that is so rare and unpredictable that it’s almost impossible to factor into the “grand equations”, including the options pricing equation. These Black Swan events are the achilles heel of forecasters. What that means in this case is this: right now with the euro/swissie artificially pegged at 1.20 Euros we have an options pricing model that does not factor this into its pricing strategy… you with me?
Let me put it a different way, essentially, what we have right now is a dam with the water rapidly rising behind it, and at some point that dam (the price pegged value freeze) is going to burst and we will see a very sudden rise in the intrinsic value (IV) of the swissie. The liklihood of this happening, we can predict with a fair amount of accuracy and not too much work.
Keep in mind that the fact this dam even exists is not considered by the currency option models which has been keeping the IV’s low. Also keeping these options prices low is the Black-Scholes-Merton model which also contains no way to factor in these “black-swan” events, and since it uses the most simplistic log normal distribution assumptions…it too is responsible for the IV’s being very low – this weakness is very exploitable and has the potential of being a big money maker provided:

– The 10 yr Italian Notes stay up over 6.70% ,

– The Italian yield curve goes inverted (Look for that to happen in the next 48 hrs), and

– The market maintains a huge comparative yield spread between italy and everyone else.

By the weekend all 3 of these factors should be in play …

According to the news wire…the Italian 10 yrs just bottomed out at 7.09% with a lot of help from the ECB.


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