Fixed Income Specialist, Saxo Bank
Summary: The hunt for yield in the bond market has resumed in earnest as investors bet on dovish policy from global central banks. Be wary, however, of the pronounced rally in Italian sovereigns as Rome's European troubles look set to come back with a vengeance in the latter part of this year.
As if the trouble in the euro area were not enough, concerns regarding the China-US trade war continue to escalate, leading many to believe that as the US economy starts to turn, the Federal Reserve will have no option but to ease policy in order to avoid a major sell-off in equities.
At present, the market is pricing three Fed rate cuts starting as soon as next month. Market expectations have provoked a strong rally in sovereigns and credits, but is there really reason to be so optimistic about bond valuations tightening further?
The truth is that is that the current rally does not seem to taking anything into consideration save central bank policy expectations. This is dangerous because just as markets have rallied into these hopes, so too could they tumble quickly if either these expectations are not met, or if other complicating factors make themselves known.
Case in point? Italy.
As you can see from the chart above, the 10-year BTPS yield has fallen by 32 basis points between the start of this month and today. The yield has hit 2.34% -- the lowest level seen since the end of May 2018, before the election prompted a sudden spike. While a rally in Italian sovereigns would seem to imply that the country is slowly stabilising on the political and economic fronts, the truth is very much the opposite.
Last week, the European Commission began its investigation of Rome’s alleged infringement of the economic terms agreed to last autumn. Not only Italy has failed to meet targets regarding public debt and spending, but the EC estimates that its deficit will increase to 3.5% by 2020. In terms of Italy’s public debt, it amounted to 132.2% of GDP in 2018 and is now slated to rise to 135% this year. Italian GDP growth has also slowed to the point of standstill, leaving no hope for an imminent recovery.
The country’s populist government, meanwhile, remains adamant that its spending plans will continue. The outspoken leader of the Lega party has made it clear that austerity will not be welcomed and continues to view spending as the preferred tool to kickstart growth. On top of this, last week saw the Italian parliament endorse a motion containing information regarding Rome’s plans to introduce “mini-BOTs”, a new type of treasury bills that the government can use to pay debt to commercial business, and citizens can use to pay taxes.
Many have argued that this is a method of introducing a parallel domestic currency that will threaten the euro. Although the motion is non-binding and carries little legislative weight, it should be enough for investors to second-guess Rome’s true intentions and grow more wary of current sovereign valuations.
The biggest risks that we see in Italian sovereigns and credit at the moment are as follows:
Sanctions from the European Commission
Although sanctions might be months away, it is clear from the EC’s report last week that Italy has met the threshold for disciplinary action. If sanctions are enforced, the country could be forced to hand in a non-interest-bearing deposit of 0.2% of GDP as a deposit to guarantee remedial action.
Higher borrowing costs undermine the effects of fiscal loosening
If Italy is allowed to loosen its fiscal policy, it still may not generate the desired level of growth as borrowing costs will gradually rise.
Possible ratings downgrade
Last week, Moody’s was quite vocal regarding the threat to investor confidence posed by mini-BOTS The ratings agency was also gloomy on the country’s growth outlook, concluding that both topics are credit-negative for the country.
Central bank policies may not prove as dovish as hoped
Even if they do, it may not be enough to support bond valuations amid political and economic turmoil.
All of these factors lead us to conclude that the rally in Italian sovereign debt went too far, too fast, and that BTPs are vulnerable to a correction. Timing, however, is key and we expect volatility in Italian sovereigns to kick off after August as Italy’s 2020 budget becomes a central topic with Brussels.
The yield on 10-year BTPs could spike to the 3.6% area previously seen last year; at that point, it may represent a buy opportunity. We believe, however, that Italian sovereigns should receive more attention in the short term as they could be one of the first assets to fall as economic constraints make their presence known. The market may well come to fear that short-term debt repayment is more of a risk than its long-term counterpart.