After a positive reaction following the agreement on a government between the League, the Five Stars Movement and the president, the market has started to take into account the lack of fiscal space of Italy with spreads rising again. It looks like there will not be any leniency from bond investors. The reaction of rating agencies will be important to watch.
As regards the risk of contagion, the good thing is that the situation is different from 2011 in many ways. First, the global environment is much more supportive. Secondly, the southern Euro area countries have current account surpluses, making them less dependent on global financing conditions. Thirdly, on the whole, banks have more solid balance sheets. Lastly, the ECB now have tools to cope with market pressures, like the Outright Monetary Transactions programme (OMT).
The forecasts for Italian bonds in view of the end of the QE
The ECB wants to stop QE by the end of the year and the hurdle to delay this process is probably very high and certainly more related to the economic outlook. So the end of QE with a bigger deficit for Italy will probably lead to the country having to pay higher yields. Market signals are important for the ECB as they enforce discipline on borrowers. In our view, unless there is widespread contagion to other countries, the widening of spreads on Italian bonds is unlikely to change the ECB’s plan.
Low chances for an 'Italexit'?
“In the short term, the odds are very limited. No party has campaigned on it and Giuseppe Conte has pledged that Italy would remain a member of the Euro area. Over the long term, one cannot be sure about the real commitment of this government to the euro. After all, getting out of the common currency has been a key idea of the League for a long time. If the government implement a large part of its program, financing conditions would probably deteriorate and the European Commission could sanction the country. In the end, this could push the country into this direction.”
“A lot of thing will depend on whether there is contagion or not. If there is contagion, then Bunds and US Treasuries will perform well. If not, the good level of global growth should support equities. Of course, companies with exposure to Italy might underperform. One has to keep in mind the monetary policy cycle. If the Fed carry on raising rates and if the ECB starts to hike interest rates, it will send bond yields higher, especially if you take into account the increase in the US budget deficit. So even if bunds and US treasuries could offer some protection when the market stress is acute, over the long run, performance will not be good.”
Julien-Pierre Nouen - Chief Economist - Lazard Frères Gestion