Market Comment – Italian bond yields still on a roller coaster

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A populist government took charge in Italy in May and has put government bond investors through an unexpected roller coaster ride ever since. Italian government bonds will remain volatile, but we may have seen the worst by now.

We suggest investors to hold on to their positions in Italian government bonds and do not exclude further rebounds from here. We think that neither the EU nor the Italian government have the incentive to escalate the situation in the short term (as happened to Greece) and drag Italy into a deep recession.

Italian ten-year government bond yields peaked at 3.25% by the end of August, as investors focussed their attention on the political debate over next year's budget, due to be discussed in parliament on 27 September. Until recently, the Italian government was headed towards an aggressive stand-off with the EU and its budget rules. Meanwhile, evidence is growing that the political uncertainty has started to spill-over to the economy. Business sentiment indicators already signal a broad stagnation in third-quarter growth data.

Sharply higher yields: financial markets’ warning signal to Italy

The rise in yields on Italian government bonds reflected growing unease in financial markets about Italy’s defiant stance towards the EU. Especially Matteo Salvini, the party leader of the League, seems to have gotten that message quickly and changed his tune markedly. Italian ten-year government bond yields dropped below 3% again on the back of much more reassuring messages from the populist party leaders intending to comply with EU fiscal rules. Importantly, a credible plan for a deficit near 2% would also significantly reduce rating risks, when Moody’s and S&P update their assessments towards the end of October. Clearly, the situation is still fluid and changing frequently, leaving markets volatile.

Italian government expected to redeem its bonds in euros

Similar to what happened in Greece, we very much doubt that Italy really dares to leave the euro and redeem their bonds in their own new currency. This would have a devastating effect on their economy, their banks and the wealth of Italian citizens. Policy makers also know that Italy’s economy is ‘too big to fail’ and its refinancing needs exceed available rescue funds in the European Stability Mechanism (ESM: an institution set up for providing financial support to euro area countries in financial distress). But as long as Italian bonds are redeemed in euros, investors will receive very attractive yields at maturity.

We therefore suggest investors to maintain a position in Italian government bonds, as we expect them to fully pay out in euros in the end. Tactical trading of Italian bonds (well-timed buying and selling) in these volatile markets is a risky investment strategy as long as markets are waiting for clarity on the new government’s fiscal agenda. It is probably too early to declare victory over the current Italian mess. However, a stand-off with the EU may well be avoided and yields, moving inversely to prices, could even fall more if the deficit for 2019 is around 2%. Therefore we think that the risks are no longer skewed to the upside.

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