August may yet prove a sleepy month for the Italian bond market, but the last week has been a reminder not to take a summer lull for granted. A renewed sell-off gripped the €2tn market late last week as the country’s populist Eurosceptic coalition government began negotiations on its debut budget, something the market had not expected until the autumn.
That has left investors sharply focused on the economic and fiscal outlook for the eurozone’s third-largest economy, as well as the potential for a stand-off with Brussels if the government, made up of the League and Five Star parties, is aggressive in its spending plans. Here are some of the key events which could prove to be flashpoints for the eurozone’s biggest sovereign bond market, where its €2tn of outstanding debt amounts to 132 per cent of the country’s GDP.
Anyone holding Italian government debt must gird themselves for what is likely to be a noisy period of negotiation over the budget ahead of a draft that is expected to be ready by the middle of October. At the heart of the process will be the question of how to reconcile the seemingly opposing policy aims of the League and Five Star parties, and the fiscal limits that Brussels expects Rome to stick with.
Last Friday, as local media reported that budget negotiations had begun, the yield on the two-year Italian bond surged as much as 40 basis points to 1.35 per cent, underlining investors’ nervousness. The yield, which moves in the opposite direction to its price, had settled back to 0.86 per cent on Wednesday.
The man standing in between the two parties will be Giovanni Tria, Italy’s finance minister, who was installed only after a previous openly Eurosceptic candidate proposed by the coalition was blocked by Italy’s president. Mr Tria has attempted to ease market fears that the budget will tear up Rome’s commitment to EU fiscal rules. However, he may have a struggle on his hands. Although the university professor, who has not worked in politics before, has pledged to keep Italy’s budget deficit within 3 per cent of gross domestic product, Mr Salvini has declared that the EU limit is “not the bible”.
A series of announcements by credit rating agencies in the coming weeks may prove a further catalyst for market movements. Fitch will be the first to publish its decision on the impact that the new coalition has on the country’s outlook, on August 31.
Moody’s, which put Italy on review for a downgrade after the coalition government was formed in May, will update its rating on September 7. Standard & Poor’s will then report on October 26. Fitch and S&P currently rate Italy as BBB with a stable outlook, while Moody’s lists the country as Baa2 and a negative outlook. In all three cases Italy is ranked two notches above junk.
It would take a pretty spectacular fall for Italian debt to drop below investment grade, but even a downgrade by one notch would leave the country hanging perilously above the crucial cut-off point which influences billions of euros of investment flows.
Italy’s Treasury recently cancelled two debt sales that were scheduled for August, meaning that there will be no new supply until early September. The most recent sale in late July was more than offset by redemptions, so net supply has been negative for most of the period since the bruising sell-off in late May when the coalition government was formed.
This has proved helpful for bond prices, but the resumption of supply next month means that effect is not likely to last. A further support for the market has been the carry trade. With Italian yields offering a considerable premium over those of other eurozone countries, particularly in shorter-dated maturities, Italian bonds have been popular among investors who expected markets to remain calm in August.
Another source of demand that will be closely watched as the negotiations unfold is Asia. Japanese investors have been shedding Italian debt since the late-May sell-off, with their net holdings falling by ¥265bn in May and June, according to recently released figures from Japan’s finance ministry. A potentially offsetting force is the Italian Treasury’s purchase of short-dated Italian bonds, including €950m-worth late last week in its third intervention in the market since late May’s sell-off.
Clearing house LCH’s decision last month to lift its margins on Italian repo deals reflected its view of the increased risk in the country’s bond market. LCH RepoClear increased the margin charged on the repo lending of Italian bonds with maturities of between three months and 10 years, with the biggest increase on two- to five-year maturities.