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Italy's spreading problems
The end of the ECB's quantitative easing programme will put Italian government bonds under more pressure.
Written by
Andrea Delitala, Head of Multi Asset Euro
Steve Donzé, Senior Macro Strategist
Italy’s latest spat with Brussels has been generating headlines. But if crisis strikes, it’s likely to come from a different direction: Frankfurt. That’s because Italy has a debt flow problem. For all the friction the country’s new populist coalition is generating with the European Commission over Italy’s proposed budget, the ultimate source of near-term market tension is the European Central Bank.
That's because Italy has been a major beneficiary of the ECB’s quantitative easing programme. Since the start of QE, the central bank’s purchases of Italian debt have outstripped the volume of new government bonds the country has issued. But as the emergency programme comes to an end, that trend will go into reverse.
Italy’s current budget imbroglio brings forward a problem that would have arisen in the coming months anyway: without ECB buying, Italian yields have to rise in order to draw in private sector funding.
In October, the ECB cut the amount of bonds it was buying under QE to EUR15 billion a month from EUR30 billion – itself a halving of the rate at which it was buying bonds in 2017 – ahead of ending it altogether before the New Year. Then, for the first time in years, price-sensitive private buyers will determine where Italian government bonds trade and, ultimately, whether country's EUR2.3 trillion debt pile - the third largest in the developed world - is sustainable.
bye bye buyer
Italian government bond spreads vs ECB purchases and Italian government issuance
*Italian government net issuance is a 12-month moving average. Source: Thomson Reuters Datastream, Banca IMI, Italian Department of Economics and Finance, ECB, Pictet Asset Management. Data as of 07.11.2018.
By the start of November, the ECB held EUR362 billion of Italian government debt, some 17 per cent the ECB’s total holdings of government bonds. As the ECB has bought less debt, Italian yields have been rising. The spread on Italian 10-year bond yields over equivalent German bunds has recently risen above 300 basis points, up from an average of 141 basis points when the ECB had its foot fully on the monetary pedal.
Current projections suggest that on a net basis, and factoring in ECB purchases, the private sector will have to absorb EUR57 billion of Italian government bonds next year. This compares with EUR11 billion in 2018 and a negative EUR54 billion in 2017 (ie there were net sales by the private sector in that year).
The question is what that means for spreads. Even if conditions calm down, spreads are unlikely to return to their averages of the past few years. As a best guess, the new range for Italian debt is somewhere between 250 to 350 basis points – the top of the range representing the level at which bank deposits flooded out of peripheral country banks during the euro zone crisis of 2010-2012. At the same time, our economists estimate that once Italian sovereign yields rise above 4 per cent, the debt becomes unsustainable, other things being equal.
As for now, concerns about Italy’s relations with its European partners mean that financial markets are starting to price in the risk the country drops out of the euro, which will contribute to the wider spread. Currently, our estimates suggest investors are demanding 200 basis points for credit risk and 100 basis points for the possibility Italy will be forced to re-denominate – we estimate that the market is pricing in a 7 per cent probability that Italy will be forced out of the euro over the next couple of years.
Italy is back on the front burner – and with reason.
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