Italy’s confidence vote is a reminder as to how politicians can talk-the-talk but when it comes to crunch time they are less willing to walk-the-walk.
The limited impact seen on sentiment stemming from the shutdown is understandable but are we too complacent as to the risks with regards to the more important debt ceiling deadline?
Politicians are known to play up the differences and the risks of a failed agreement only to reach a compromise at the eleventh hour. This is how the process works whether this is in Italy or in the US. Democrats and Republicans are showing no signs of reaching an agreement with President Obama willing to highlight the risks of a default.
But the markets continue to look past the near term ratcheting up of the heat, and are focused on an eventual likely agreement. The VIX might have come off its lows but at 17.5% is still not at levels that would suggest concern from the market.
While equity vol players are sanguine it’s a different matter for those trading bills with the 1-month Treasury bill yield at its highest level since Nov-2012, with the 1m yield now above the 1-year yield.
The US CDS price has also ticked higher but from very low levels. This is where the risks related to the debt ceiling is showing up and given that we still have a long way to go before Oct 17 there could be yet more in the way of upside.
Markets will price in the risks as opposed to trade the risks as many are still sitting close to neutral having been flushed out of their positions after the Fed no-taper shocker heading into quarter-end.
Using very OTM calls on bunds seems an attractive means of playing the tail risks for those concerned that the market is complacent over the debt ceiling deadline. In a world where there has been a sharp decline in the supply of AAA paper the rating implications of a default would only make other safe havens that much more attractive.
We (like the market) expect an eventual agreement and will look to use the uncertainty heading into mid-October to re-establish shorts and curve steepeners on bonds as well as paying 12x24 SONIA forwards.
On the latter we did a 50% pay position on 12x24 SONIA and 1y1y GBP at 0.68% and 1.03% respectively.