David Roberts

Where next for Italian bonds?

David Roberts

Many market commentators are saying that a yield of 2.5% for 10-year Italian sovereign bonds is a key level for the European Central Bank (ECB). At that level, it is thought the bank would start to buy more bonds and prevent yields rising further – but I do not believe that it the case.

First, why would ECB President Mario Draghi want to bail out Italian Eurosceptic populists right now? Let Five Star and The League feel a little pain until they have formed a government: once they see the price to be paid for populism, it is much more likely they will work to stay in the system. Giving them an opportunity to reduce dependence on Europe makes no sense.

Draghi is of course well remembered for his “whatever it takes” speech from 2012, when he pledged to go all out to protect the euro. Of course, his intention was, and still is, to hold Europe together and not to make life easy for those who want to move away from the Union. It is worth remembering the extent to which the ECB played hardball with Greece until that government was forced to accept eurozone and IMF bailout conditions. Doing whatever it takes to keep the eurozone together naturally includes punishing rogue states who threaten to leave: the UK should take note.

What really matters to the ECB is not the level of Italian yields but the yield differential to the eurozone’s risk -free asset, namely German bunds. In simple terms, the euro single currency and unified monetary policy across the eurozone rests in the long term on equilibrium between nation states. If Italian borrowing is too high compared to Germany, it is more difficult for Italian industry to compete with German: there is no currency to devalue, as with Brexit, to regain an advantage.

Yield differential between Italian and German 10-year Bonds

David Roberts: where next for Italian bonds? - Yield differential between Italian and German 10-year Bonds

Source: Bloomberg, as at 23.05.17       

The chart shows that for much of 2017, Italian bonds traded more than 2% above bunds. Draghi would clearly have been concerned at that time, and this, in part, explains why ECB monetary policy remained so accommodative in buying a disproportionate amount of Italian debt. There was no panic.

Could Draghi buy Italian debt again? Yes, of course – but calling a line in the sand at 2.5% for Italian yields is nonsense. A yield differential of 2.2%-2.25% relative to Germany in the longer term is probably excessive in Draghi’s mind.  I suspect it is likely we see the ECB try to stem flows around that level if we are there or wider at the end of summer.

However, that could easily mean 10-year Italian bond yields rising above 3% in the short term, handing investors a loss of nearly 10% since the middle of April. 

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Wednesday, May 23, 2018, 3:35 PM