Rising Italian bond yields to test an ECB set to trigger another rate hike

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A light symphony of bars, lines and circles in blue and yellow, the colors of the European Union, illuminates the south facade of the European Central Bank (ECB) headquarters in Frankfurt, Germany December 30, 2021. REUTERS/Wolfgang Rattay

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LONDON, Sept 2 (Reuters) – Rising borrowing costs in debt-ridden Italy are once again testing the European Central Bank’s resolve to contain bond market tensions.

Just days before the ECB is tipped to launch a second big rate hike to curb record-high inflation, fears of a more aggressive move have unsettled investors.

The Italian 10-year bond yield topped 4% on Thursday for the first time since mid-June, as a sharp move above that level pushed the closely-watched spread on German debt to around 250 basis points, prompting the ECB to hold an emergency meeting to discuss how attachment stress can be curbed because it removes the stimulus.

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Testing the 4% market on Italy’s BTP yield

This level is widely viewed as a level at which concerns arise about Italy’s ability to service its debt. At around 150% of gross domestic product (GDP), Italy has the second-highest debt ratio in the euro area. Continue reading

Societe Generale believes Italian yields are entering a “danger zone” with 10-year borrowing costs now above their estimate of the level at which the debt ratio would remain stable.

In July, the ECB presented its Transmission Protection Instrument (TPI) in view of the dangers of tightening monetary policy against the background of sharply rising borrowing costs. It’s a new bond-buying program to help more indebted eurozone countries and prevent borrowing costs from drifting away from benchmark emitter Germany, which he says is through no fault of his own. Continue reading

“Everyone in the market knows that 4% is difficult for debt sustainability in Italy and that the growth outlook has deteriorated,” said Laureline Renaud-Chatelain, fixed income strategist at Pictet Wealth Management.

However, analysts suspect the new tool is unlikely to be deployed any time soon – especially with snap general elections in Italy on September 25.

“The yield level will be a problem. But I don’t think the ECB will activate the new instrument before an election,” said Renaud-Chatelain.

Renewed political instability in Italy has contributed to the sell-off in bonds, while the recent rise in yields is consistent with comparatives. Italian and German 10-year government bond yields each rose about 70 basis points in August as fears of higher inflation and higher interest rates took hold.

The risk premium over Germany has widened by around 235 basis points but is below recent highs, possibly helped by the ECB distorting reinvestments from maturing bonds it bought for its pandemic purchase program in Italy.

“The spread remains orderly and more than 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.

PAIN LIMIT?

Nonetheless, markets were expected to continue pushing yields higher to test the ECB’s tolerance level for Italian bond market pain.

Historically, analysts have viewed the 250-300bps spread area as a danger zone for the ECB and some analysts expect the spread to reach this area in the coming months.

Italy’s 10-year yield spread to Germany

UBS, for example, thinks the spread could test 300 basis points.

Meanwhile, Italy’s borrowing costs climbed to new multi-year highs at an auction on Tuesday. Continue reading

“Nobody knows when the ECB will start to intervene, and of course they won’t tell us,” said Mike Riddell, senior fixed income portfolio manager at Allianz Global Investors.

“Since the announcements of potential support for the periphery and Italy in particular, I expect markets to test (the ECB) given the trajectory of economic growth and interest rates.”

With energy prices soaring, many economists expect the eurozone economy to slip into recession – a challenging backdrop for the ECB as inflation approaches double digits.

On the plus side, election noise in Italy hasn’t worried investors so far.

The Italian legal alliance’s ambitious spending plans will respect the European Union’s fiscal rules and will not leave a hole in Italy’s finances, according to Giorgia Meloni, who leads the Italian Brothers party, which leads the polls. Continue reading

“The worrying thing for the market was that Italy’s yields would rise and the growth outlook would be significantly worse after (former Prime Minister Mario) Draghi left,” said Peter McCallum, Mizuho’s rates strategist. “It now looks like the policy won’t come as much of a shock as some people feared.”

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Reporting by Dhara Ranasinghe, Tommy Wilkes and Yoruk Bahceli, editing by Jonathan Oatis

Our standards: The Thomson Reuters Trust Principles.

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