A toxic cocktail for Italian bonds

Oleg Elkov/iStock via Getty Images

By Paolo Pizzoli, Antoine Bouvet, Francesco Pesole

Bonds are taking a beating this year. In the case of Italian sovereign debt, volatility has been aggravated by the disproportionate influence that the European Central Bank is buying played in setting market prices. These purchases are about to end in early July and have already decreased significantly. With this reality now widely recognized and markets having had time to prepare for a world of tighter monetary policy, are Italian bonds off the hook?

No short-term debt sustainability issues

Italy, burdened by longstanding high public debt, remains vulnerable to interest rate hikes. When these materialize, as is currently the case, the question of debt sustainability arises. While we see reasons for concern in the medium term (the spring 2023 general elections are raising uncertainties and questions about what the ECB will do with its BTP QE portfolios), we believe that in the short term, the risk of sustainability debt remains contained for two reasons. The first concerns the maturity structure of Italian debt. With an average maturity slightly over seven years, the transmission of the rise in interest rates to the entire stock of Italian public debt takes time. It is estimated that a sustained shift of 100 basis points up the curve would add some €3 billion to interest costs in the first year and just under €6 billion in the second year. These are manageable amounts in a non-urgent environment.

A high average maturity means that higher interest rates will take some time to affect public finances

A high average maturity means that higher interest rates will take time to affect public finances (Datastream, ING)

The second reason has to do with the cautious attitude of Prime Minister Mario Draghi and Finance Minister Daniele Franco in terms of budgetary policy. They seem well aware that in a normalizing world, Italy will follow a narrow path in its public finances, and so far they have resisted pressure from some parties within the ruling coalition to anticipate a deficit that deviates from the objectives, even in the face of recent dramatic events. events. The latest decree, which extended measures to help businesses and households weather the storm of energy prices, is an example of this, as the additional spending is financed by an increase in a windfall tax on energy producers. ‘energy. We expect Draghi to try hard not to give in, well aware that if the European Commission were to extend the suspension of European PSC rules until 2023, it could revive the morale of some deficit-prone members of government, particularly in a pre-election year context.

The ECB is no longer the buyer of last resort…

We tend to divide the influence of the ECB on financial markets into direct and indirect effects. In the case of Italian bonds, the direct effect of the purchases is to remove a large amount of assets from private markets, causing a kind of artificial scarcity. Even when the ECB stops buying bonds, the direct impact of past purchases should remain to some extent. As a percentage of the amount of Italian debt available for purchase by private investors, the ECB’s share will only gradually decrease by the amount of new debt sold by the sovereign to finance deficits.

Italian bonds are one of the assets most affected by monetary tightening

Italian bonds are one of the assets most affected by monetary tightening (Refinitiv, ING)

Indirect effects are more difficult, but not impossible, to quantify. In the case of Italian bonds, the ECB played the role of buyer of last resort. This means that in the eyes of private investors, the central bank was perceived as being there to come to the rescue in the event of financial difficulties. Those who spoke of an ECB put were not far from reality. In short, the ECB purchases were seen as removing the tail risk of investing in Italian bonds. As a result, they were perceived to be less risky and investors felt justified in seeking lower returns.

…but it may soon backtrack to stop widening spreads

We interpret the talk of a hypothetical facility to prevent fragmentation (ECB language for spread widening) as an attempt to restore the ECB put. The strategy appears to deliberately give investors as little detail as possible. If the strategy is to avoid the market testing specific levels of spreads or yields, it has its merits, but we believe it will fail. In essence, he acknowledges that Italian bonds cannot be traded without central bank support. The goal of making this support as light as possible is laudable, but markets have a definite history of testing the extent of ECB support.

Absent ECB intervention, spreads will continue to widen as base yields rise

Absent ECB intervention, spreads will continue to widen as base yields rise (Refinitiv, ING)

We have no fundamental concerns about Italy per se. Debt sustainability is not yet a concern, interim measures to address the eurozone fiscal architecture have been taken in the EU NextGeneration recovery plan, and there is a more constructive stance on public investment. For now, the current market environment of worsening risk appetite and tightening monetary conditions is toxic for sovereign bonds, including Italy. We expect markets to test the ECB’s plan in the near term, pushing 10yr spreads to Germany to 250bps. In the longer term, aided by more concrete support from the ECB and as market volatility subsides, we expect investors to look more favorably to Italy as an issuer.

EUR/CHF: the correlation with the BTP-Bund spread is weaker than on other occasions

EUR/CHF is more likely to show the highest sensitivity to movements in peripheral spreads than EUR/USD, given the franc’s role as the ultimate hedge against Eurozone downside risks. The correlation between the pair and the 10-year BTP-Bund has historically been quite inconsistent: very strong in periods of Italian bond market and bond market distress, and very weak during calmer periods.

The chart below shows how breaks above (and also below) the 200 basis point mark in the BTP-Bund spread have historically been the level around which the negative correlation between EUR/CHF and the spread tended to reach its maximum. This suggests that the 200bp mark has often represented a key benchmark, above which market concerns over Italian debt have effectively triggered an increase in defensive short positions in EUR/CHF.

Is 200 bp the key level for a EUR/CHF reaction?

Is 200bp the key level for a EUR/CHF reaction? (ING, Refinitiv)

As we can see in the correlation chart above, the EUR/CHF-BTP correlation has strengthened recently but remains lower than it was in previous instances when the BTP-Bund spread was around the 200 basis point mark.

We believe this partly comes down to the fact that the euro is already pricing in a fair amount of negative sentiment due to high energy prices and the EU-Russia standoff, which raises the bar for a negative impact from peripheral spreads on the currency. At the same time, the Swiss franc has followed a somewhat unusual trajectory, having first been allowed to strengthen significantly by the Swiss National Bank (which welcomed a strong franc to curb inflation) in March and April, but after apparently resuming the broad policy divergence between the ECB and the SNB and returned to the 1.04-1.05 zone against the euro, despite the risk aversion environment.

Incidentally, markets may feel less concerned about Italian spreads, as weakness in the construction market is now more “imported” by ECB policy rather than related to political or economic unrest in Italy.

Until Italian spreads (and other peripheral eurozone spreads) widen to a level that triggers a reassessment of ECB tightening expectations or serious debt sustainability concerns emerge, the correlation with the EUR/CHF might not increase much further from the current levels. This does not mean that the FX impact of widening spreads will be small, just less pronounced than in previous cases (like 2011 or 2018). Indeed, downside risks for the EUR/CHF remain significant, especially given the SNB’s seemingly higher tolerance for a strong franc. We only expect a recovery above 1.05 EUR/CHF in the last quarter of 2022.

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Garland K. Long