While we don’t want to get drawn into the Byzantine world of Italian politics, we do have a thing or two to say about bond markets. What has struck us the most about the Italian bond market has been the degree of volatility in BTPs and drop in liquidity. The first chart below shows that the daily change in the 2-year bond yield dwarfed the experience of 2011, while the second shows the blowout in the bid-ask spread.

Although quantitative easing has flooded the banking system with liquidity in the form of reserve money, the ECB has removed a large chunk of sovereign bonds from the market. The ECB now owns 20% of Italian debt. In addition, since the global financial crisis investment banks have scaled back from fixed income trading.

As such, vulnerability to VaR shocks has likely increased, although this can be difficult to detect since lack of liquidity typically shows up in times of stress. This is a major systemic financial risk. This episode also highlights mispriced sovereign credit risk in the periphery and the potential for wider core-periphery spreads.

(Click on image to enlarge.)

Supporting charts about the drop in the Italian bond market

Source: Bloomberg, Macrobond and Variant Perception