http://themacrotourist.com/images/GermanSep2616.png

In early summer, as the markets were reeling from the unexpected British vote to leave the EU, Italian banks came under pressure. Worried it might spread to a full blown panic, Italian politicians and banking officials prepared for the possibility of state sponsored bailouts. But the Germans quickly kiboshed that sort of foolish talk. From Reuters:

BRUSSELS Germany and the European Commission told Italy on Wednesday to follow the rules after Italy made preliminary plans to prop up its banks in the wake of volatility caused by Britain’s vote to leave the European Union.

Rome says it is concerned that Italian banks, which hold 360 billion euros ($400 billion) of bad loans, a third of the euro zone’s total, risk attack by hedge funds betting that market turmoil could tip them into full-blown crisis.

Banking and government sources said Italy was preparing to protect its banking industry by requesting more flexibility from the EU on both public spending and state aid for its lenders.

The Italian initiative did not go down well in Germany, the main contributor to the EU budget and a staunch supporter of fiscal discipline and strict rules.

“On the banking union we established specific rules as far as the winding down of banks, the recapitalization of banks is concerned,” German Chancellor Angela Merkel told a news conference after a summit of EU leaders in Brussels, the first after Brexit.

“We can’t come up with new rules every two years,” she said, replying to a question about Italy’s requests.

http://themacrotourist.com/images/MerkelSep2616.jpg

Fast forward to today. Deutsche Bank shares are getting hammered as Merkel maintains a strict “what’s good for the goose is good for the gander” policy. From the FT:

Deutsche Bank’s head of communications, Jörg Eigendorf, has sought to clear up some of the speculation that has put the lender’s shares under renewed pressure today.

To recap: the shares earlier dropped to a low of €10.63, the lowest level since Deutsche started trading on the Xetra exchange in 1992, although it traded below that level in the early eighties.

The fall came after German magazine Focus reported that Chancellor Angela Merkel had ruled out providing any state aid for the bank. The group has also been the focus of short-sellers amid wranglings with the US Department of Justice.

Some of the bulls were hoping the crucial suport at €11.10 would hold, but with Merkel’s stern rebuff, the price of Deutsche Bank has collapsed to new lows.

http://themacrotourist.com/images/DBSep2616.png

http://themacrotourist.com/images/DBLTSep2616.png

Although Germany is mouthing words about equal treatment for Deutsche Bank, how realistic is this option? Europe is a slow moving car wreck and the longer Germany insists on austerity, fiscal tightening and balanced budgets, the worse it will get.

Europe is engulfed in a deflationary vicious circle. Making banks sell assets to meet increased capital requirements, while increasing taxes and reducing spending to balance government deficits chokes off any hope of achieving growth, which only increases the real debt burden, thus forcing even more sales of assets, etc…

As Orwell said, all pigs are equal, but some pigs are more equal than others. We all know that Deutsche Bank is the most equal pig of them all, but how long will Merkel & Co. maintain their bluff? The longer it goes on, the worse it will get.

I worry it will take a crisis before Germany finally acts. I can’t bring myself to short DB as it is just so darn cheap. I still hold hope the Central Banks’ monetary bonfire finally ignites and we find ourselves with the much awaited inflation, but I realize so far, this seems like a pipe dream. Regardless, I am not willing to hop on the short DB train, as it is a crowded short.

Yet I acknowledge the market will most likely keep squeezing Germany and Deutsche Bank until the situation is resolved. I would like to have some sort of hedge in case this momentum accelerates.

Like a chump, I am currently short German Bunds. For a brief time last week, it looked like yields might break out, but the 10 year bund has once again slipped solidly back into negative territory.

http://themacrotourist.com/images/BundsSep2616.png

To hedge a little bit of my offside trade, I am swapping some of my bund short into an Italian BTP short. The spread between the 10 year Italian and German government bond has been tracing out a long rounded bottom.

http://themacrotourist.com/images/ItalySep2616.png

In the event of continued Deutsche Bank stress, the demand for high quality German government bund assets should drive this spread wider. Not only that, but if Deutsche Bank starts to topple, then there is no way Italian banks will not also fall.

And to top it off, in the coming months as various European countries head to the polls, the risks of an EU breakup will be increasingly priced into the market.

For my book, shorting Italian bonds and covering some German bunds makes way more sense than trying to play Deutsche Bank from the dark side.

Thanks for reading,
Kevin Muir
the MacroTourist