Volatility Volatility Volatility

Volatility will shake up Italian government bonds

Bonds
Althea Spinozzi

Senior Fixed Income Strategist

Summary:  Prepare for volatility to strike Italian BTPS once again. The Italian yield curve is likely to bear-flatten as coronavirus distortions will keep long-term yields in check. However, short-term yields will soar amid fading ECB support. Once covid fears ease, long-term yields will accelerate their rise. Yet, the political context remains critical. If Draghi accepts to become President, we might be facing a fractured political system posing even a bigger and imminent threat to BTPS. In the long term, we remain constructive Italian sovereigns and see the BTPS-Bund spread tightening as a new German government works towards better European integration.


Let’s talk about the elephant in the room: the periphery.

As inflationary pressures continue to grow and central banks consider more aggressive monetary policies, we see volatility in rates rising globally. The spread between government bonds from the periphery and Bunds continues to widen, putting at risk one of the very goals of the European Central Bank: maintaining favorable financing conditions in the euro area.

Usually, investors look at the BTPS-Bund spread to understand whether risk sentiment is souring. However, this time around, I want to do something a little unconventional. By looking at the 10-year spread between Italian Spanish, Portuguese and Greek government bonds, we better understand what's happening in the most volatile market of the euro area. The cost of funding in Italy is rising faster than in Spain and Portugal; however, it is soaring slower compared to Greece. It means that the market is not merely looking at each country's political and economic backdrop; it's putting great importance on liquidity as well. Indeed, Greek government bonds are by far the most illiquid sovereigns in the euro area.

However, why Italian BTPS are falling faster compared to Spanish Bonos and Portuguese Obligaciones? A quick answer to this question is that Italian BTPS have a higher beta compared to the two. Yet, that doesn't give the complete picture. Italian BTPS have been underperforming their peers because they are highly dependent on the ECB support (specifically the PEPP program) and rumors of another possible political turmoil.

Source: Bloomberg and Saxo Group.

Italian BTPS: divided between covid, inflation, and political pressures.

Currently, three elements are driving BTPS performance:

  1. New covid wave
  2. ECB support
  3. Political backdrop

The new covid wave and the lack of hard scientific evidence concerning the omicron variant are prevalently driving European long-term yields. Bonds are sticking to the idea that further restrictions will hinder economic growth, compressing yields. However, we expect this to be a temporary distortion that will solve as fears concerning the new variant ease, and we get towards spring.

More concerning are instead the forces that continue to put upward pressure on yields.

Investors are increasingly worried about fading ECB support, and we believe that these fears are not unfounded. Inflation in the eurozone recently rose to 4.9% YoY, the highest on record since the introduction of the euro currency. Italy's CPI soared to 4% YoY, while the country's monthly PPI index hit 7.1% in November.

Policymakers are increasingly worried that inflationary pressures will be stickier, especially since supply chain bottlenecks appear unlikely to resolve until 2023. Within this context, it's doubtful that the ECB's monetary policies will remain accommodative for longer, posing a threat to all countries that depend heavily on its support, such as Italy. The central bank intends to end the PEPP program in March, as announced in the summer, worrying BTPS holders. The biggest beneficiaries of the PEPP program have been Italian and Greek government bonds. Without an eligible substitute, yields will soar quickly.

However, the imminent problem is how the ECB is going to deal with the announcement of the end of the PEPP program in December. Suppose it doesn't decide on any enhancement concerning existing asset purchases programs. In that case, the periphery, particularly Italian BTPS, is likely to throw a tantrum. The longer the central bank wait to relax other facilities’ rules (such as the ones for the APP) or introduce a new purchasing program, the less likely it is for policymakers to see scope to support bond purchases amid sustained inflationary forces, putting more pressure on BTPS.

Within this context, the spike in 2-year BTPS makes sense.

Source: Bloomberg and Saxo Group.

Lastly, the political backdrop adds to investors' worries. Since Draghi entered the political scene, it has been a smooth ride. However, now that president Mattarella is to leave the Quirinale in January, political parties are trying to push the former head of the ECB to take this role. That would be a gamechanger for Italian politics because the President will need to appoint a new technical government or call an early election. The problem with this notion is that Draghi is an essential figure when it comes to the country’s relationship with the EU. The Italian economic recovery depends on European financing. With Draghi, Italy has the certainty that the money of the NextGenertionEU fund will be spent according to plans and that the necessary reforms will be implemented. This way, Europe will continue to finance the recovery. Without Draghi, the country faces the risk of a fractured political system, risking that anti-European parties will come at play again, threatening the country’s international credibility.

By focusing on the omicron outbreak, the market is underplaying this political risk, which may play out in just a few weeks.

Italian yield curve: bear-flatter first to bear-steepen later.

The above means that Italian yields are poised to rise, and the BTP-Bund spread to widen. While covid distortions will continue to keep yields in check, they will accelerate their rise once this cap is removed.

We expect to see Italian yields higher across the curve in the upcoming months. However,  the most imminent risk is for the front part of the yield curve to spike if the ECB doesn’t tread carefully its message surrounding the ECB. In the meantime, the long part of the yield curve will remain in check amid a new wave of covid.

In case of political turmoil, long-term yields will rise despite covid news. Yet, if Draghi remains as premier, it's likely we won't see yields soaring until fears concerning covid are eased. Yet, as a new wave of Covid comes to an end with the PEPP program, it will be unavoidable to see the long part of the yield curve adjusting higher with 10-year yields rising to 1.3%.

As a consequence, we'll see the BTPS-Bund spread widening, although at a slower pace. Higher BTPS will be accompanied by higher Bund yields touching a maximum of 150bps before resuming its long-trend tightening. Indeed, we remain constructive BTPS in the long term as we see the new German government working towards better European integration.

Source: Bloomberg and Saxo Group.
Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website is not intended to and does not change or expand on this. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-hk/legal/disclaimer/saxo-disclaimer)

Saxo Capital Markets HK Limited
19th Floor
Shanghai Commercial Bank Tower
12 Queen’s Road Central
Hong Kong

Contact Saxo

Select region

Hong Kong S.A.R
Hong Kong S.A.R

Saxo Capital Markets HK is a company authorised and regulated by the Securities and Futures Commission of Hong Kong. Saxo Capital Markets HK Limited holds a Type 1 Regulated Activity (Dealing in securities); Type 2 Regulated Activity (Dealing in Futures Contract) and Type 3 Regulated Activity (Leveraged foreign exchange trading) licenses (CE No. AVD061). Registered address: 19th Floor, Shanghai Commercial Bank Tower, 12 Queen’s Road Central, Hong Kong

By clicking on certain links on this site, you are aware and agree to leave the website of Saxo Capital Markets, proceed on to the linked site managed by Saxo Group and where you will be subject to the terms of that linked site.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the US and other countries. AppStore is a service mark of Apple Inc.

Please note that the information on this site and any product and services we offer are not targeted at investors residing in the United States and Japan, and are not intended for distribution to, or use by any person in any country or jurisdiction where such distribution or use would be contrary to local law or regulation. Please click here to view our full disclaimer.