Italian bank stocks (FTSE Italia bank index) declined a modest 2.3% Monday on the back of Sunday’s resounding defeat of Italian Prime Minister Renzi’s political reform referendum. The bank index then proceeded to surge 9.0% Tuesday, 4.5% Wednesday and another 3.6% Thursday, for a stunning 27% rally off November 28th trading lows. “Par for the course,” as they say.  Italian 10-year sovereign yields rose eight bps Monday, yet by Wednesday’s close yields were actually lower on the week. Italian sovereign CDS ended the week little changed. Italian stocks gained 7%.

Following Brexit, Trump’s win and Renzi’s defeat, hedging market risk has been relegated to the status “senseless lost cause”. A short squeeze and unwind of hedges fueled this week’s 12.7% Italian bank rally, along with a 9.5% surge in European banks that reverberated in Asia (Japan banks up 5.6%), the U.S. (banks up 5.4%) and globally. Especially in Europe, a reversal of bearish hedges created powerful buying power. It’s a common trading strategy to purchase put options with proceeds from selling out-of-money call options. Increasingly in the U.S. and in Europe, equities trade as if those on the wrong side of derivative (calls) trades are being forced to hedge exposure by aggressively purchasing stocks into a rapidly rising market. It’s a self-reinforcing market dislocation similar to that which not many months back fueled a historic collapse in global bond yields.

One is left to assume that there must be some silver lining to Renzi’s defeat and resignation. From a fundamental perspective, it’s not obvious where to look. Italy’s anti-establishment Five Star Movement and Northern League political parties are salivating at the thought of new elections possibly early in the year (some speculating February). The Continent’s anti-euro and anti-establishment parties are emboldened. Meanwhile, the slow-motion Italian banking train wreck is chugging along.

December 9 – Reuters (Silvia Aloisi and Paola Arosio): “The European Central Bank has rejected a request by Italy’s Monte dei Paschi di Siena for more time to raise capital, a source said…, a decision that piles pressure on the Rome government to bail out the lender. Italy’s third-largest bank, and the world’s oldest, had asked for a three-week extension until January 20 to try to wrap up a privately funded, 5-billion-euro ($5.3 billion) rescue plan… The ECB’s supervisory board turned down the request at a meeting on Friday on the grounds that a delay would be of little use and that it was time for Rome to step in… The Italian government is expected to intervene in the next few days to recapitalize the bank to avert the risk of it being wound down, according to banking sources…”

Monte dei Paschi, Italy’s third-largest bank, saw its shares halted Friday down 10%. With a private-sector recapitalization now in doubt, a government rescue would test the EU’s new rules for forcing “bail in” losses upon bondholders. Italian banks have sold large quantities of bonds to unsuspecting retail customers, creating the potential for significant political fallout in a period of already heightened public anger. There are also the serious issues of further capital flight out of Italy and even bank runs.