Italy’s budget turmoil: Here’s what it will take to rattle global markets


Investors woke up Friday to find Italy’s populist government back on what’s widely described as a collision course with the European Union and, perhaps, so-called bond-market vigilantes. But turmoil appeared largely contained. So, when should global investors start to worry?

Frederik Ducrozet, senior Europe economist at Swiss money management firm Pictet, perhaps summed it up best on Twitter, noting that a sharp selloff by Italian government bonds caused barely a ripple in Spain’s bond market. In other words, no contagion so far.

Italian bonds had rallied over the past month, pulling down yields and narrowing the all-important yield premium demanded by investors to hold Italian paper over risk-free German government bonds, on expectations the country’s new government would increase its budget deficit only modestly in 2019 despite promises by the leading coalition parties—the far-right League and the antiestablishment 5 Star Movement—on basic income, pension reforms and tax cuts.

Read: Italy budget turmoil roils markets: What investors need to know

But those bond bulls were caught wrong-footed at the end of this week after the country’s independent economics minister, Giovanni Tria, appeared to give in to pressure from coalition leaders. The budget target released late Thursday pegs the 2019 deficit at 2.4% of gross domestic product, up from 0.8% this year and well above the 1.6% that had reportedly been advocated by Tria. Meanwhile, Italian Prime Minister Giuseppe Conte on Friday denied any tensions with Tria amid reports he had offered to resign in protest. Conte said Tria told him in a phone call he had never made such an offer, Reuters reported.

Reports of tensions between Tria and other government officials sparked weakness in Italian bonds Thursday, while the subsequent unveiling of the deficit target was followed by a Friday rout that left the yield on the 10-year Italian bond

TMBMKIT-10Y, +8.62%

 up nearly 25 basis points at 3.138% after earlier trading above 3.20% to its highest since late August.

Fears the deficit figure could trigger downgrades by credit-rating firms, push up long-term debt levels and endanger Italy’s compliance with EU budget rules, setting the stage for a fight with Brussels, drove the reaction, said analysts.

The spread between the 10-year Italian bond and 10-year German bund yields

TMBMKDE-10Y, -10.94%

 widened more than 31 basis points to 2.7 percentage points after hitting the widest since early September. Spain’s 10-year yield

TMBMKES-10Y, -0.11%

meanwhile, edged 0.6 basis point lower to 1.502%.

Meanwhile, a boost in the deficit of around 1% of GDP, equal to a modest 17 billion euros ($19.7 billion), would be relatively easy for investors to absorb, wrote economists at Société Générale.

The concern for investors, on the other hand, is the “capacity for liabilities to grow and mastery of the budget execution over the course of 2019” by Italy’s Treasury, they said.

“But for now, the present Italian government seems rather strong with the League and Five Star together firmly directing” the Treasury, they said. “So investors will need reassurance on this front.”

Adverse headlines and fears of downgrades are both likely to remain factors ahead of the European Commission’s review of the country’s budget plans, with credit-rating firm Moody’s Investors Service set to complete a review by the end of October, said Giovanni Montatti, analyst at UBS, in a note. Italy is rated Baa2 by Moody’s, two notches above junk.

But he’s skeptical that Italy’s investment grade rating will be jeopardized and he also doubts the fiscal target will spark a lasting escalation of bond-market volatility by itself.

“While risk-reward for long BTP positions has deteriorated following the recent rally, we would fade any large selloffs in Italian bonds,” he said, in a Friday note.

Friday’s Italian market moves were big but still leave yields far from crisis levels. Italian stocks sold off sharply, with the FTSE MIB index

I945, -3.72%

 logging a 3.7% fall and serving as a drag on other European bourses. The euro

EURUSD, -0.2834%

 fell but trimmed losses to remain down around 0.3% versus the dollar. And U.S. stock were little changed after some initial weakness, with the S&P 500 index

SPX, +0.06%

 trading near unchanged and the Dow Jones Industrial Average

DJIA, +0.13%

 holding on to a 0.1% gain.

Shares in Italian banks bore the brunt of the weakness in the country’s equities, owing to their exposure to sovereign bonds. Worries about Italy’s banks have periodically sent shivers through European markets since the global financial crisis.

On Friday, shares of Intesa Sanpaolo SpA

ISP, -8.44%

 fell 8.4%, while UniCredit SpA

UCG, -6.73%

 dropped 6.7%. The pullback comes after a rally, trimming Intesa Sanpaolo’s September gain to 3.5%, while UniCredit saw a 4.3% monthly rise.

Matenatti said there could be more “moderate pressure” on banks, but that he saw no “material risk” to earnings forecasts while the institutions’ capital positions would depend on what happens with BTP spreads.

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Source : MTV