Rising Italy bond yields to test an ECB set to pull rate hike trigger again
LONDON — Rising borrowing costs in highly-indebted Italy are again testing the European Central Bank’s resolve to contain bond market strain.
Just days before the ECB is tipped to deliver a second big interest rate hike to curb record-high inflation, worries about a more aggressive move have unnerved investors.
Italy’s 10-year bond yield on Thursday topped 4% for the first time since mid-June, when a sharp move above that level pushed the closely-watched spread to German debt to around 250 bps and prompted the ECB to hold an emergency meeting to discuss how to contain bond stress as it withdraws stimulus.
This level is generally viewed as one where concern about Italy’s ability to service its debt sets in. At around 150% of gross domestic product (GDP), Italy has the second-highest debt to-GDP ratio in the euro area.
Societe Generale believes that Italian yields are entering a “danger zone” with 10-year borrowing costs now above its estimate of the level at which the debt ratio would remain stable.
Alert to the dangers of tightening policy against a backdrop of sharp rises in borrowing costs, the ECB unveiled its Transmission Protection Instrument (TPI) in July. It is a new bond purchase scheme to help more indebted euro zone states and prevent a divergence of borrowing costs from benchmark issuer Germany it sees as happening through no fault of their own.
“Everyone in the market knows that 4% is tricky for debt sustainability in Italy and the growth outlook has deteriorated,” said Pictet Wealth Management fixed income strategist Laureline Renaud-Chatelain.
Yet, analysts suspect the new tool was unlikely to be used soon – especially as a snap Italian election looms on Sept. 25.
“The yield level is going to be a problem. But I don’t think the ECB will activate the new tool before an election,” Renaud-Chatelain said.
Renewed Italian political instability has contributed to the bond sell-off, while the recent yield surge is in line with peers. Italian and German 10-year yields rose around 70 bps each in August as fears about higher inflation and rates took hold.
The risk premium over Germany, at around 235 bps, has widened but is below recent peaks, supported perhaps by the ECB skewing reinvestments from maturing bonds it bought for its pandemic purchase scheme at Italy.
“The spread remains orderly and more than the level it is the behavior of the spread (and more generally the periphery) that the ECB would be concerned about,” said Peter Schaffrik, global macro strategist at RBC Capital Markets.
Still, markets were expected to keep pushing yields higher to test just where the ECB’s tolerance level for pain in Italian bond markets lies.
In the past, analysts have viewed the 250-300 bps area in the spread as a danger zone for the ECB and some analysts expect the spread to reach this area in coming months.
UBS, for instance, reckons the spread could test 300 bps.
Italian borrowing costs meanwhile climbed to new multi-year highs at a Tuesday auction.
“No one knows when the ECB will start intervening and they obviously won’t tell us,” said Mike Riddell, senior fixed income portfolio manager at Allianz Global Investors.
“My assumption since the announcements of potential support for the periphery and namely Italy, is that markets will test (the ECB) given the trajectory for economic growth and rates.”
Battered by soaring energy prices, many economists expect the euro zone economy to slip into a recession – a challenging backdrop for the ECB as inflation nears double digits.
On the plus side, Italy’s election noise so far hasn’t alarmed investors.
The Italian rightist alliance’s ambitious spending plans will respect European Union budget rules and not blow a hole in Italy’s finances, according to Giorgia Meloni, who heads the Brothers of Italy party topping the polls.
“The worrying thing for the market was that you’d have Italy’s yields rising and a considerably worse growth outlook after (former Prime Minister Mario) Draghi left,” said Mizuho rates strategist Peter McCallum. “It now seems like politics isn’t going to be so much as a shock as some people have been fearing.”
(Reporting by Dhara Ranasinghe, Tommy Wilkes and Yoruk Bahceli, Editing by Jonathan Oatis)
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