Fixed Income Specialist, Saxo Bank Group
The yield on Italian BTPS has been stable, trading around 1.8% since the elections back in March, but as the market realised that nothing good could have come out from a coalition of two populist parties leading to the formation of a government, the Italian bond sell-off intensified and the spread between BTPs and bunds spiked to 185bps – a level previously seen in June of last year. Now that the Five Star/League coalition’s proposal points have been presented, investors are finally appreciating that the risk ahead is too high.
Rumours regarding a guaranteed minimum income and a flat tax rate of 15% didn’t do much to worry investors, but as news emerged last week that the parties were looking to ask the European Central Bank for a €250bn write down of the country’s debt, investors understood the gravity of the situation. Although the final agreement between the Five Star movement and League no longer mentions the possibility of debt forgiveness, the ongoing talks about deficit reduction still include a peculiar request for Eurostat: to remove from the calculus of debt levels those bonds that were acquired by the ECB during the quantitative easing put in place for the purposes of EU budget rules.
This would resolve part of the question on how to fund the parties’ very expensive policy programme as at the moment, EU rules limit government budget deficits to 3% of GDP and Italy’s government budget deficit is currently around 2.3%.
This is likely a sticking point for investors, as removing these bonds from the deficit calculus doesn’t make this debt disappear. The budget deficit will grow as thr coalition’s populist policies are implemented and while bond repayment by the Italian government is still expected, underlying problems such as slow growth and a weak financial banking sector will undermine the performance of the country, if not the European area as a whole.
It is therefore clear that both of the parties don’t understand the forces underpinning a healthy economy, and as a consequence they don’t know how to implement expansionary policy without compromising the country’s future. Although the coalition has now softened its stance regarding the reduction of the deficit point, there is still a huge potential risk for investors to buy the dip at this moment, as things could quickly get out of hand.
Eurosceptism: the threat within
It is incredible to think that Italy is one of the founding members of the European Union. Although both parties have softened their stances against the EU and Di Maio swore at the beginning of the year that he will not even consider a referendum to exit the EU, we cannot forget that both parties flirted with just this for a long time, and that it remains something of an active risk.
League leader Salvini has mentioned several times that if the EU refuses to re-negotiate fiscal and economic rules, he will not hesitate to pull the country out of the Union. Considering that one of the coalition proposals redefines the definition of deficit, and that the EU is unlikely to give much ground on this point, we can expect more volatility surrounding this topic, which will negatively affect EUR and Italian sovereigns.
Potential for another debt crisis on the periphery, if not a wider European crisis
There is potential for things to get worse before they get better. If conversations with the EU to enable Italy to issue more bonds in order to fund the coalition’s expensive agenda get out of hand, we can expect volatility to spike to levels previously seen during the debt crisis of 2011/2012 throughout the periphery.
We can see from the chart below that, as the BTPS tumbled last week, the Spanish, Portuguese, and even the French spreads against the bund spiked. The country that will be hardest hit by the Italian volatility is Greece, where the economy is just recovering form a debt crisis and is seeking to end its bailout programme during the summer.
We cannot rule out the possibility that if Italy receives favourable conditions regarding its debt, Greece will join forces with the government in Rome to put pressure on the EU and get its own piece of the pie.
Weak Italian financial sector to spook the market
Italian banks have been struggling for many years, and it was only last summer that Monte dei Paschi di Siena received a €5.4 billion bailout by the Italian government after the EU approved it. Now, the plan signed off by Italy’s new ruling parties states that the “mission” of the bank should be to serve the community, and it is not certain that the new government will be able to abide by the previously agreed exit plan
If complications arise, this may be a catalyst for the wider Italian financial sector. Another factor that may drag Italian banks down is the fact that over time they have accumulated huge stakes of Italian sovereign debt. Lenders as big as Banco Popolare have Italian government bonds on book top the tune of twice their core capital.
A fall in Italian sovereigns might therefore have serious consequences on the country’s financial sector.