Italian Prime Minister Mario Draghi. Photo/PA
Investors are wondering how far Italy’s borrowing costs can rise before they tear a hole in the heavily indebted country’s economy as selling intensifies in eurozone bond markets .
Yields rose in the block
since the European Central Bank last week signaled the end of the stimulus measures it stepped up at the start of the coronavirus pandemic. ECB President Christine Lagarde confirmed her intention to withdraw a large-scale bond-buying program and initiate interest rate hikes next month to combat record levels of inflation.
In turn, Italy found itself in the market’s sights, due to its need to refinance a borrowing burden of around 150% of gross domestic product. Investors are dusting off the calculations of the eurozone debt crisis a decade ago as they try to figure out when rising yields could start to jeopardize the finances of the Italian government as well as businesses and households .
“You can tell things are bad because people are starting to post about Italian creditworthiness again,” said Mike Riddell, bond fund manager at Allianz Global Investors. “The market isn’t panicking yet, but all this focus on Italy is starting to look a bit like 2011,” he added. At the time, concerns over Italian debt sustainability pushed Italy’s 10-year yield to an all-time high of over 7%. It hit an eight-year high of 4.06% on Tuesday.
The spread between Italian and German 10-year yields peaked at 5 percentage points at the height of the debt crisis a decade ago. Andrew Kenningham, an economist at Capital Economics, said he didn’t think the ECB would let it get that high, predicting it would intervene once it hit 3.5 percentage points.
The recently extended average maturity of outstanding Italian debt, to over seven years, means that the recent rise in yields will only gradually trickle down to the country’s average interest cost, according to Goldman Sachs analysis. However, seven-year borrowing rates have already topped 2.75%, the maximum level at which Rome’s debt burden would stabilize, the bank said. Italian seven-year debt was trading at a yield of 3.79% on Tuesday.
As Prime Minister Mario Draghi’s market-friendly government faces an election next year, any political instability “may well end up being a catalyst for renewed debt sustainability concerns,” Goldman Sachs said.
Investors are also watching the spread between Italian and German borrowing costs – the so-called gap – which has widened to 2.4 percentage points from around 2 percentage points before the ECB’s meeting. last week.
The central bank has pledged to tackle the so-called “fragmentation” of the eurozone financial system, but investors were baffled by a lack of details last Thursday on a new “instrument” to limit spreads.
Fund managers like Riddell, who bet against Italian bonds, believe Italy’s spread has yet to reach levels that would prompt the ECB to intervene in the markets. “The ECB had the opportunity to be more accommodating and they turned it down,” Riddell said. “It’s almost an invitation to the market to cause more stress.”
Yields rose further on Tuesday after Dutch central bank president Klaas Knot told Le Monde that the ECB would not limit itself to a half-point rate hike in September, opening the door for a move. by 0.75 percentage points.
“We are getting closer to the danger zone,” said Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management, adding that Italy’s debt trading ease had deteriorated somewhat.
“I understand why the ECB is reluctant to move,” Ducrozet said. “But…if bond yields breach the pain threshold, the revaluation could become self-fulfilling and the ECB would be unable to stop it unless it intervened massively.”
Along with the longer maturity profile of its national debt, Rome also benefits from more than 210 billion euros ($351.7 billion) in grants and cheap loans from the EU’s Next Generation recovery fund.
But the ECB is concerned about a disproportionate rise in Italian borrowing costs, not only because of the sustainability of public debt, but also because they serve as a floor for the overall financing costs of businesses and households. In the first four months of this year, average Italian mortgage rates rose from 1.4% to 1.83%, a three-year high, according to the ECB.
Italy’s central bank said the amount of medium and long-term debt the country needs to refinance will drop from 222 billion euros this year to 254 billion euros next year, which, combined with the drastic drop ECB purchases, should add upward pressure on yields. .
Rome may have to rely more on Italian financial institutions to buy more of its debt, which could reignite concerns about banks’ vast exposure to domestic sovereign debt.
At the end of April, Italian banks held more than 423 billion euros in domestic public debt securities and 262 billion euros in loans to their government, slightly below their record levels of 2015 following the crisis of the Eurozone debt, according to ECB data.
If it increases further – and foreign investors were already reducing their exposure to Italian sovereign bonds last year – it could reignite fears of a vicious circle between private sector lenders and governments that undermine each other and ultimately threaten the economy. existence of the single currency area.
“Eurozone banks are in better shape in terms of capitalization and stock of non-performing assets,” said Lorenzo Codogno, former chief economist at the Italian Treasury. “Yet they still have a large position in domestic government bonds in many countries. The catastrophic loop of sovereign banks may yet be triggered.”
Written by: Tommy Stubbington and Martin Arnold