BNY Mellon: BTPs and a Sense of Calm

6 mrt 2019

The eurozone’s economic slowdown is bringing with it a growing possibility that markets could revisit one of 2018’s dominant issues before too long: the Italian debt saga – something with the potential to capture the EUR’s attention.

Since 2008, the two-year DE/US yield gap has been a good guide to EUR performance (200-day moving correlation has been over 70% more than half the time). But in recent times, European politics have seriously interrupted this relationship.

The post-April 2017 EUR rally and slide in the yield relationship came directly in the aftermath of the first round of the French presidential election, for example, and the decline from the middle of April last year coincided directly with rising political turbulence in Italy.

The new Italian government’s threat to ignore the EU’s fiscal rules last May saw BTP/Bund spreads blow out to levels last seen in the crisis years, while the EUR relinquished ground which it has yet to recover.

After a gradual, six-month slide, the EUR notably began to stabilize in late November when Matteo Salvini’s concession to “budget revisions” paved the way to the December budget agreement between Italy and the EU.

But although tensions have eased, normality has yet to return to the Italian sovereign debt market. Shorter-term yield spreads – though elevated - have eased, certainly, but the 10-year BTP/Bund spread has averaged 278 bps since the December agreement, which bears comparison with 292 bps from last May through to year end.

The point here is that, but for a thirst for yield generally (a 10-year Greek auction this week was four times oversubscribed), relative stability, even at these elevated spreads, would unlikely have materialized. And certainly, the Italian Treasury has not been slow to realize an opportunity.

By early last month, the Treasury had raised almost 15% of its planned issuance for this year; and an allocation of 15-year Italian bonds at the start of the year attracted a record subscription.

Clearly, to some extent, investors have learnt to live with the Italian economy’s chronic underperformance, but their custom still demands confidence in solid financial governance, and particularly from a ministry that has neither printing press nor policy flexibility to fall back on.

Hence from the standpoint of relative stability in the BTP market, what really matters is that Italy’s dimming economic outlook once again puts it on firm collision course with the EU.

Indeed, with the Italian economy now in recession, warnings that the government’s debt-fueled stimulus would be offset by higher borrowing ring true. In such an environment, fresh TLTROs – if they are to be forthcoming – may soften the blow, but their potential to stimulate growth must be open to question.

After months of wrangling, the EU/Italian deficit agreement was predicated on GDP growth of 1.1% in 2019; but the eurozone’s export-gearing has fallen prey to the changing global climate: the Commission now predicts the Italian economy will grow by only 0.2% -  the OECD predicts a contraction - and suffice it to say, pressure on the deficit will almost inevitably rise beyond what was agreed. 

Economy Commissioner Pierre Moscovici said last week: "The lack of progress in [the implementation of reform] unfortunately leads us to conclude that Italy's macroeconomic imbalances remain excessive”. Accordingly, the Commission has said it will "closely monitor developments" and warns that it could “take action” against Italy later this year, based on the EU's spring economic forecasts.

But unless the spring forecasts – scheduled for May 9th – somehow defy the present gloom, then the very real prospect of a fresh Italy-EU standoff beckons.

And under such circumstances, the relative calm that has sustained investors’ interest in Italian debt could be rudely disrupted – something with potential implications for the EUR market, if 2018 is anything to go by.