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Rising Italian bond yields to test ECB ready to pull rate hike trigger again

By on September 2, 2022 0

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

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

Just days before the ECB is set to make a second major interest rate hike to rein in record inflation, concerns over a more aggressive move have unnerved investors.

Italy’s 10-year bond yield rose above 4% on Thursday for the first time since mid-June, when a sharp breach above that level pushed the closely watched spread on German debt to around 250 basis points and prompted the ECB to hold emergency meeting to discuss how to contain bond stress as stimulus is withdrawn.

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Testing the 4% market on the yield of Italian construction

This level is generally seen as the one that raises concerns about Italy’s ability to service its debt. With around 150% of gross domestic product (GDP), Italy has the second highest debt-to-GDP ratio in the eurozone. Read more

Societe Generale believes that Italian rates 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.

Alerted to the dangers of policy tightening amid soaring borrowing costs, the ECB unveiled its Transmission Protection Instrument (TPI) in July. This is a new bond-buying program designed to help the most indebted states in the eurozone and prevent a divergence in borrowing costs from benchmark issuer Germany, which he considers to be occurring through no fault of his own. Read more

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

Still, analysts suspect the new tool is unlikely to be used anytime soon, especially as a snap Italian election looms on September 25.

“The level of return is going to be a problem. But I don’t think the ECB will activate the new tool before an election,” Renaud-Chatelain said.

The resurgence of Italian political instability has helped sell off bonds, while the recent surge in yields is in line with peers. Italian and German 10-year yields rose about 70 basis points each in August as fears of higher inflation and rates took hold.

The risk premium on Germany, at around 235 basis points, has widened but is below recent highs, supported perhaps by the ECB’s biased reinvestments of maturing bonds it bought for its pandemic purchase program in Italy.

“The spread remains orderly and more than the level it is the behavior of the spread (and more generally of the periphery) that would concern the ECB,” said Peter Schaffrik, global macro strategist at RBC Capital Markets.


Still, markets needed to keep pushing yields higher to test the ECB’s level of tolerance for trouble in Italian bond markets.

In the past, analysts considered the 250-300 basis points area of ​​the spread as a dangerous zone for the ECB and some analysts expect the spread to reach this area in the coming months.

Italy’s 10-year bond yield spread versus Germany

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

Italian borrowing costs meanwhile hit new multi-year highs at an auction on Tuesday. Read more

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

“My assumption since the announcements of potential support to the periphery and in particular to Italy, is that the markets will test (the ECB) given the trajectory of economic growth and rates.”

Battered by soaring energy prices, many economists expect the eurozone economy to slide into a recession – a difficult backdrop for the ECB as inflation approaches double digits.

On the positive side, the noise of the elections in Italy so far has not alarmed investors.

Italy’s right-wing alliance’s ambitious spending plans will respect European Union budget rules and won’t blow up Italy’s finances, according to poll-leading Giorgia Meloni, who leads Italy’s Brothers party . Read more

“What is worrying for the market is that Italian yields would rise and growth prospects would be much worse after the departure of (former Prime Minister Mario) Draghi,” Mizuho’s rate strategist said, Peter McCallum. “It now looks like the politics won’t be 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

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