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Since 2008, hedge funds have placed their largest bet against Italian debt

Due to growing worries about Rome's political unrest and the nation's reliance on Russian gas imports, hedge funds have placed their largest bet against Italian government bonds since the beginning of the global financial crisis.

According to data from S&P Global Market Intelligence, the total amount of Italian bonds borrowed by investors to bet on a decline in prices hit its highest level since January 2008 this month, at more over €39 billion.

Investors are rushing to bet against Italy as the nation faces growing economic challenges from the rise in European natural gas prices brought on by Russia's supply cuts as well as a tense political environment with elections in September.

"It’s the most exposed [country] in terms of what happens to gas prices, and the politics is challenging," according to Mark Dowding, chief investment officer at BlueBay Asset Management, which manages about $106 billion in assets. He is employing futures-based derivatives to short Italian 10-year bonds.

Last month, the IMF issued a warning, stating that unless other nations shared their supplies, a Russian gas embargo would cause an economic downturn of more than 5% in Italy and three other nations.

By raising interest rates and stopping the bond purchases that have supported the country's enormous debt market, investors believe Italy to be one of the nations most vulnerable to the ECB's plan to dismantle its stimulus programmes.

A period of comparatively peaceful political affairs that Mario Draghi's accession as prime minister in February 2021 had ushered in was disrupted in July of this year when the former head of the ECB announced his resignation and his national unity coalition government fell apart.

September will now see early elections, with nationalist leader Giorgia Meloni widely regarded as the favorite to succeed Silvio Berlusconi as premier. Draghi urged the political parties running in the elections on Wednesday to follow through on their pledges to modernize Italy's banking system.

The right-wing coalition, which according to polls could win up to 50% of the vote on September 25, has signaled that its euroskeptic parties may evaluate the specifics of Italy's €200 billion EU-funded recovery plan and any accompanying reforms, such as a new competition legislation.

"“Domestic credibility goes hand in hand with international credibility," according to Draghi.

As a result of investors' reaction to the growing unpredictability, Italian bonds have already started to decline recently. Italy's 10-year debt now has a yield of 3.7%, increasing the difference between it and Germany's debt, a key risk indicator, to 2.3 percentage points from 1.37 percentage points at the beginning of the year.

According to one significant hedge fund investor, "Italy seems like it is going to be the most vulnerable [country]" to deteriorating economic conditions. He added that such bets were now "widespread," with many managers betting on the spread between German and Italian bonds.

According to records viewed by the Financial Times, Michael Hintze, the founder of the hedge fund CQS, was one among those who benefited from wagers against Italy's bonds earlier this year. CQS opted not to respond.

Because of the country's €2.3 trillion in outstanding government bonds and ongoing political unrest, betting against Italian debt has historically been a very profitable investment for hedge funds.

Alan Howard, a co-founder of Brevan Howard, benefited from hedge funds increasing their bets to the greatest level since the financial crisis in 2018, as markets worried about whether a coalition government would increase debt levels and loosen connections with the EU. However, hedge funds' wagers have now surpassed 2018 levels in both absolute terms and as a percentage of the overall bond issuance, giving investors hope for where yields may go from here.

Some managers continue to be cautious about the trade, claiming that the recently revealed transmission protection tool by the ECB will restrict yield upside. The new instrument was created to prevent borrowing costs in heavily indebted eurozone countries from exceeding those in Germany and other important core countries.

Decio Nascimento, chief investment officer at hedge firm Norbury Partners, who is avoiding the deal, said, "It seems to me [it's] like playing a game of chicken with the ECB."

The TPI, according to BlueBay's Dowding, is not a major obstacle to placing a bet that is bearish.

He added that such a step would serve as a signal that the bank would offer assistance to nations lacking budgetary prudence, thus "[the ECB] can't just buy Italy."


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