The past couple of weeks have been characterised by investor uncertainty and volatility due to political turmoil in Italy. This fuelled one of the largest sell-offs in Italian government debt since the eurozone debt crisis, albeit still below 2011-2012 levels.
It is likely that the sell-off was mainly driven by the fear that the Five Star Movement and the League coalition would appoint a eurosceptic finance minister and adopt expensive fiscal policies that would put pressure on public finances. Yields were pushed higher on fear that Italy may be en route to new elections, which markets expected would turn into a referendum on Europe.
The yield on the Italian 10-year sovereign bond reached 3.15 per cent last week, up from 1.73 per cent two months ago, however well below the 7.24 per cent yield reached in the 2011 high. The spread on German benchmark debt rose to almost 290 basis points (bps), reflecting investor demand for a greater risk premium to hold Italian debt. More generally, euro area peripheral bonds weakened while demand for safe-haven assets pushed the German 10-year bond yield to as low as 0.19 per cent last week.
The move in spreads extended to other eurozone peripherals, including Portugal and Spain. Portuguese and Spanish 10-year bonds widened to 190bps and 134bps from 110bps and 72bps respectively amid the recent political uncertainty. However, the risk on peripheral bonds seems to be relatively contained, as the risk of anti-euro stance in Italy has calmed down.
In fact, heightened risk aversion subsided when the coalition between the Five Star Movement and the League proposed an alternative finance minister. The coalition government was approved by President Sergio Mattarella, averting new elections. Additionally, the anti-euro rhetoric has become less prominent.
However, markets are still wary of the fiscal reforms proposed by the new Italian government. The implementation of the controversial programme promised by what many consider ‘populist’ parties is now a major focus for investors. There is concern that their plan would cause significant increases in the country’s debt levels, which is already the second highest in Europe at almost 132 per cent of GDP.
The programme includes increasing welfare and benefits, trying to reduce corporate and individual tax (via a ‘flat tax’) and an overhaul of 2011 pension reforms which raised the retirement age. The implementation of these measures would put further pressure on government finances and will likely result in disagreements with the European Union.
Markets are wary of the fiscal reforms proposed by the new Italian government
Although the new government has indicated that an exit for the euro will not be pursued, there is a realistic risk of a weakening of Italy’s credit profile. Ratings agencies, including Moody’s and Fitch, have warned that the plans posed a risk to the countries’ credit profile, due the potential damage of reforms on Italy’s debt sustainability and failure to reform the economy.
This scenario would likely push yields higher, as a credit downgrade could increase the cost of new borrowing. Debt sustainability is unlikely to be an issue in the short term; nonetheless the country’s large debt stock makes Italy more vulnerable to shocks in the long term.
The more immediate risk is one of increased volatility in financial markets, as investors react to the ongoing developments. In fact, the market’s sensitivity to these reforms, including that of Italian bonds but possibly also of the wider peripheral debt market, can be highlighted by the recent Italian government debt sell-off that followed Prime Minister Giuseppe Conte’s inaugural speech.
The yield on the 10-year Italian government bond was pushed up over 30bps, back up to 2.9 per cent.
It is important to note that so far, the European sovereign bond market has been cushioned by the European Central Bank’s Quantitative Easing programme, which on the basis of current indications is due to end in September this year.
The accommodative monetary policy has been viewed as being supportive of bond prices, and thus questions on whether uncertainty, in the absence of QE, will have a spiralling effect on euro-peripheral debt, have been raised.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.
Martina Gabarretta is a research analyst at Curmi and Partners.
www.curmiandpartners.com