The election of an anti-establishment government in Italy sent investors fleeing and Italian government bonds (BTPs) witnessed record outflows earlier this year. Antonio Ruggeri, manager of the OYSTER European Corporate Bonds fund at SYZ Asset Management, argues recent BTP weakness is linked to fiscal policy uncertainty and could come to an end once a Budget proposal is tabled.
It would be wrong to assume markets are punishing the choices of the Italian electorate. The mess started in May this year, more than two months after the Italian general election.
Populist coalition didn't faze BTPs
During the election campaign and for the first few months after the election, anti-euro and anti-EU rhetoric was essentially dismissed by the Five Star and the League. Investors were expecting that whatever the government, Italy would continue on its fiscal path.
If we look at spreads versus German sovereigns on 10-year, and perhaps more importantly 2-year maturities, Italian bonds behaved pretty well in the aftermath of the political elections, notwithstanding the victory of populist parties: 10-year spreads were down at 115 in April and 2-year yields were only 25 basis points higher than German rates on the same maturity.
The root cause of bond weakness
To understand why Italian bonds are disliked by investors today, we need to look at what drove spreads higher in May, after so much complacency in March and April. The reason is simple: in May, the Five Star Movement and the League started to work on a common programme, which included a huge increase in government expenditure without appropriate coverage and the will to challenge the eurozone institution on its debt, reigniting Italexit fears.
The market is now pricing in a weakening of fiscal discipline and a so far very low probability of ‘Italexit'.
Over the last two months, however, markets have been receiving mixed messages. On side, finance minister Giovanni Tria has been reassuring on fiscal discipline and dismissing plans to leave the eurozone, and on the other, prominent political speakers have been making statements referring to the possibility of breaching European budget constraints.
So far, this has caused a shift in risk premia and a spike in volatility, an environment which will most probably last until the budget law is submitted to the European Commission for approval.
The imminent end of the QE program added to market nervousness, but since maturing bonds will be reinvested and monetary policy will remain very loose for a while longer, this has had a milder impact so far, relative to fiscal policy uncertainties.
BTPs could recover
The Budget announcement will be the real test for markets: we expect the government to announce a modest increase in deficit spending versus the projected path, adhering to coalition promises. In this scenario, BTPs could recover, but it is hard to imagine them reaching early spring levels.
Uncertainty will continue to weigh on Italian sovereigns until real numbers are disclosed; this is why Moody's announced it will put Italy's rating under review only after the Budget.