Will Italy be downgraded to junk?

Yvan Berthoux - 11 October 2018

Italy, home of the third-largest sovereign bond market in the world (after US and Japan) and the third-worst general government balance sheet in the world (after Greece and Barbados), is gambling with arguably its greatest national asset: the privilege of government borrowing at paltry interest rates, virtue of irrevocable membership of the European Monetary System. What may have seemed a mild and entirely justified relaxation of the fiscal stance, in the light of abysmal economic progress, has erupted into a full-on market assault. The reaction to the announcement of a higher than expected budget of 2.4 per cent of GDP (versus 1.6 per cent, anticipated) for the next three years was an immediate re-pricing of 10-year BTPs, currently trading at a yield above 3.5 per cent, its highest since February 2014. With the 5-year CDS at 272bps, credit default protection is now more expensive for Italy than South Africa (230bps) and Brazil (221bps), whose sovereigns are both rated as junk. Investment grade status is hanging by a thread, and with it, membership of elite bond indexes. A very slippery slope awaits.

To be clear, Spanish bonds are untainted by this furore. While the 10-year spread between the BTP and Bund yield is approaching 300 basis points, Spanish bonds have remained steady with the benchmark spread averaging 100bps in the past two months (figure 1, right frame). The question of Italy’s debt sustainability has poignancy as we approach the time when the ECB terminates its bond purchase programme.

According to the latest IMF’s World Economic Outlook, Italy’s GDP is expected to grow by 1.2 per cent and 1 per cent in 2018 and 2019, respectively, which ranks it as the second-weakest outlook (after Japan) among the advanced economies. Our leading indicator (figure 2, left frame) shows that Euro area countries were already facing a headwind in the coming months, however the increase in political and growth uncertainty in the last few months has elevated the term premium in Italian bonds as non-resident holders have required higher compensation for holding interest rate risk. The growth-to-interest-rate (GIR) differential, one of the key drivers of the dynamics of the debt-to-GDP ratio, has been negative since the beginning of the year, which may weigh on the country’s budget deficit in the medium term.

In periods of market stress, non-resident holders (NRH) started to sell their Italian debt securities when long-term interest rates were rising (figure 3, right frame). On the other hand, Italian banks are net purchasers of domestic government bonds; some sell-side institutions have shown inflows from Italian financial institutions were higher than those seen during the European sovereign debt crisis of 2012, when the 10-year bond was trading at 6.5 per cent that July. Can the Italian bond market survive an ECB exit in the medium term? Where does the neutral interest rate on a 10-year bond stand without the central bank’s helpful bid (figure 3, right frame)?

The current environment has obviously been negative for Italian equities, which are down by almost 20 per cent since their highs. The FTSE MIB index broke below its psychological 20,000 support level, which corresponds to the 50% Fibonacci retracement of the 15,000 – 24,550 range. By some measures, Italian equities are already in a bear market. The risk premium that has attached to Italy’s sovereign bonds applies with no less intensity to its equity market. Backing down on fiscal reform is going to be very hard for the Italian government to swallow, but investors are ever hopeful.

Figure 1

Data source: Eikon Reuters, Bloomberg and Trading Economics

Figure 2

Data source: Eikon Reuters, Economic Perspectives

Figure 3

Data source: Eikon Reuters, Bank of Italy

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