(Bloomberg) — A slump in European bond markets is driving up Italy’s borrowing costs to the point where traders are wondering how much pain policy makers can take before stepping in to prop up its debt.
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Benchmark borrowing rates for Italy, one of the euro area’s most indebted nations, hit 2% in the past week for the first time since pandemic-induced market turmoil in 2020. The prospect of reduced stimulus from the European Central Bank means the likes of BlackRock Inc. is betting on its bond yields still climbing further.
The selloff has already taken the premium investors demand for holding Italy’s so-called BTP debt over Germany’s — a key gauge of risk — to about 170 basis points. Above 200 is seen as a warning sign, and above 300 can hit the front pages in Rome. In that range, analysts are speculating the ECB might need to resume buying more bonds.
“We see the ‘danger zone’ for BTP spreads at around 250 basis points,” said Frederik Ducrozet, global strategist at Banque Pictet & Cie SA. “If spreads widening got out of control, then we could imagine the ECB setting up a new backstop facility.”
That played out in March 2020, after the Italian spread jumped above 300 basis points in the wake of ECB President Christine Lagarde saying she was not here to “close spreads.” The ECB then reversed course and announced a new pandemic emergency purchase program. Markets globally are now worried about the risk of new policy mistakes in 2022.
Saxo Bank A/S also points to 250 basis points as a potential danger zone. For ING Groep NV strategists it’s lower, at about 200 basis points.
“Historical precedence is the best guide to the ECB’s pain point,” said Eimear Daly, a currency strategist at Barclays Plc. “We are still far from these levels. However, the market would view a widening of the Italy-bund spread to this degree as a test of the ECB’s resolve.”
Earlier in the pandemic, the ECB was clear about preserving financing conditions, but its focus has now shifted to easing stimulus to rein in red-hot inflation. Its pandemic bond purchases, of which Italy has been one of the main beneficiaries, are due to end next month.
If it does need to step in, flexible bond reinvestments could be a first line of defence. That should be sufficient to stabilize the Italian spread over Germany to around 200 basis points, according to BNP Paribas SA strategists including Sumati Semavoine-Jain.
Not All Bad
On the plus side for Italy is a rosier financial outlook than in the past. Borrowing costs are still low by historic standards and won’t filter through to debt servicing straightaway. The economy is also set to benefit from more than 200 billion euros of European Union Recovery Fund money.
Commerzbank AG’s head of interest-rates strategy Michael Leister points out that, even in the absence of an ECB backstop, European solidarity constitutes a soothing factor for investors and rating agencies alike, as long as Italian politics remains calm. That’s currently the case, with former ECB chief Mario Draghi at the helm.
Draghi’s Italy Is Better Placed to Handle ECB’s Hawkish Pivot
If yields keep rising, that may also fuel interest among foreign buyers. Once hedging costs are taken into account, Japanese investors get an Italian yield of about 1.87%, compared to a hedged yield of about 0.33% for 10-year Treasuries, according to Cosimo Marasciulo, head of investment absolute returns at Amundi SA.
“That’s something that might convince global investors to look at that market with interest,” he said.
Still, for Italy, its debt burden remains high, at more than 150% of output. In a recent speech, Bank of Italy Governor Ignazio Visco said it will be necessary to rebalance the structure of public accounts gradually and steadily to avoid tensions in the government bond market.
It’s not just the spread versus Germany that the ECB will be watching. According to Deutsche Bank AG’s Ioannis Sokos, it’ll also be monitoring the pace of widening, since extreme volatility could deter some investors. That matters because price sensitive funds will have to step in to replace the ECB, which has been gobbling up bonds at any price.
For BlueBay Asset Management’s Mark Dowding, recent comments from ECB officials suggest they are not troubled because absolute yields remain low. That’s an approach he says could be termed “benign neglect.”
Next Week
ECB speeches include Vice President Luis de Guindos and executive board member Isabel Schnabel. The Bank of England’s David Ramsden has his first speaking engagement since voting for a 50-basis-point rate hike earlier this month, while Governor Andrew Bailey is also scheduled to talk on a couple of occasions.
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Euro-area, German and U.K. PMI figures for February as well as German Ifo numbers are highlights on the data agenda, while French February CPI may hold clues for the following week’s release of euro-area and German inflation numbers.
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German and Italian bond sales are set to total 12.5 billion euros ($14.2 billion), according to Commerzbank AG. The U.K. is next scheduled to sell gilts in March.
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