Standard Life Investments

Global Outlook

Italian reboot

Developments in Italy are set to dominate sentiment across European bonds. It’s important to recognise what’s at stake.

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The European bond market remains dominated by Italian questions. Will Italy’s ongoing budget negotiations produce a result that leads to an improved growth trajectory? Will the proposals be sufficiently balanced to satisfy Italy’s European partners, the European Commission and the rating agencies? But perhaps most importantly, can the European Central Bank (ECB) pursue a policy of reducing quantitative easing (QE) in parallel with such an atmosphere of political and economic uncertainty in one of the Eurozone’s largest economies?

The country’s nascent government is faced with a dilemma. As is well-known, Italy has run a primary surplus for many years, yet it is no nearer to either generating economic growth or meaningfully improving the country’s debt dynamics. Each of the parties in the Five Star and Lega coalition have stressed the importance of negotiating a new and fairer relationship with Europe. Both parties are performing strongly in the polls. But their leaders are still behaving as if they are in electoral campaign mode (although this is perhaps understandable given the Italian predilection for frequent elections).

This constant electioneering – and the promises to the electorate that accompany it – leaves investors  struggling to reconcile the pledges with a budget deficit which could adhere to the 3% European Union limit under its Stability and Growth pact.

The summer lull ahead of the budget negotiations had been expected to give some period of relief for the Italian bond market. There was a six-week break in supply and a continued eager (or forced) buyer in the shape of the ECB, alongside domestic private sector funds reinvesting maturing cash.

But what we actually saw was a general lack of activity and, perhaps more critically, a lack of risk appetite more generally. Even the late August Italian five-year bond auction, which should have represented the sweet spot of domestic interest, was marred by unfortunate timing, coinciding as it did with a risk-off tone in emerging markets (this time caused by a burgeoning crisis in Argentina).

Bond investors are also rebooting their view on Italy more generally, as they struggle with the opposing risks around holding this risky credit. On the positive side, Italian debt is already reflecting many of the concerns around an even more complicated political environment, and investors are already demanding a higher return than for Spain and Portugal to compensate for the enhanced level of risk.

Bond investors are also rebooting their view on Italy more generally, as they struggle with the opposing risks around holding this risky credit.

However, Italy’s status as the largest sovereign bond market in the Eurozone ties it inexorably to the outlook for those markets, too. Should Italian debt weaken further then the threat of contagion could begin to push Spanish and Portuguese spreads wider.  This puts the ball back into the ECB’s court. So, if Italy is deemed “too big to fail”, where does this leave the ECB’s desire to rein in its own version of QE?

One of the key effects of the ECB’s QE programme (aka the Public Sector Purchase Programme, or PSPP),  was the smoother transmission of monetary policy across the Eurozone, with all sovereigns benefitting from lower borrowing costs and more homogenous yields. The PSPP is now scheduled to cease by the end of 2018.

One of the strongest criticisms of the programme was that it introduced moral hazard–the idea that as an instrument of policy rather than an indicator, yields would no longer provide a barometer of the health and trajectory of a sovereign’s debt. They would therefore stop providing any sort of feedback to governments or investors over the credibility of government plans in areas such as fiscal policy.

The original rationale for the QE programme was to dig Europe (and in particular its banks) out of the hole created by the global financial crisis and to try to avoid the deflation risk that accompanied it.

With both of these tasks (arguably) near their conclusion, and given that the ECB has a single mandate to target inflation, the justification for this extraordinary policy is now waning.

Given this backdrop, it has become too politically sensitive to entertain the idea of an extension of the PSPP. Accordingly, from the beginning of 2019, a price-insensitive buyer will disappear from the bond market place. With ECB President Draghi’s tenure scheduled to end in October 2019, the policy support backdrop for all peripheral debt will be under increasing scrutiny – and this has significant implications for those bond yields perceived to be most supported by it. 

All of this may hint at the requirement for a more subtle and supportive policy response from the ECB. 

While the official date that net purchases end is 31 December 2018, the ECB has yet to clarify how it will treat re-investments of debt rolling to maturity within its QE stock portfolio. When QE ended in the US, re-investments of maturing bonds continued for years afterwards.  In the Eurozone, the ECB could introduce some tweak to its own reinvestment programme and extend the average maturity of the bonds they re-invest into. If no official announcement is made, then each national central bank could unilaterally switch its repurchases into longer maturing debt.

This, in a sense, would be the path of least resistance, a more gradual removal of QE to avoid a hard shock by using the same sort of “Operation Twist” type approach that was adopted in the US. Sure, there is still some moral hazard attached to such an approach – but perhaps less so than before. Policy makers and investors will watch with interest.

Chart 1: Italian debt dynamics

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