Italy is at an inflection point. Not just because Prime Minister Mario Draghi unveiled the mother of all stimulus packages this week, but also because Italian bond yields are inching up to their highest levels for more than six months. The huge leap toward an economic recovery can only be achieved if the costs for the nation’s ballooning borrowing needs are kept in check.
This is where the European Central Bank, Draghi’s former employer, really has to have his back by reassuring bond markets that it will keep buying as much Italian debt as needed. This will keep the “gentlemen of the spread” — the League leader Matteo Salvini’s memorable description for bond traders — in check and ensure the differential to German Bunds remains controlled.
With a bit of luck, investors might even appreciate the higher yield that Italy offers compared to the rest of Europe (bar Greece) — just as a predicted second half economic recovery kicks in. Only then can a moment of peak vulnerability pass into the rear-view mirror.
NatWest analysts reckon investors need to buy about 70 billion euros ($85 billion) of Italy’s new issues this year, net of ECB purchases. The key target is foreign purchasers, who hold only about 30% of Italy’s sovereign debt, much less than the percentage for other major European countries. But international bond buyers need to know the water is safe to enter.
Italy’s fate rests on former ECB President Draghi not only presenting a competent plan, but efficiently delivering on it — something that his prime ministerial predecessors have failed to achieve. The stakes have rarely been as high for the euro project, which depends on the future wellbeing of its third-largest economy.
The European Union’s 750 billion-euro pandemic recovery fund, of which Rome will be the leading recipient, can only do so much of the heavy lifting. Italy’s net new borrowing will be 200 billion euros this year, so it requires someone with Draghi’s reputation to instill confidence.
He can’t do that alone. His ECB replacement, Christine Lagarde, has to carry on his “whatever it takes” mantra and resist the hawkish elements on the central bank’s governing council who want to rein in its pandemic bond-buying program (PEPP) before the mission is even properly underway — let alone accomplished.
Fortunately, there are some promising signs. After conflicting signals in recent weeks, the latest weekly ECB data showed a “significantly higher pace” of 22.2 billion euros of bond purchases. At the most recent ECB meeting Lagarde signaled that this quickening will continue at least until the ECB’s June 10 meeting. It’s crucial that she prevails with a clear message that support for Italian bonds is unwavering. (It’s not just Italy that relies on the central bank’s backbone support: My credit market colleagues point out that corporate spreads are priced for perfection, too.)
To trim back now as Italy commits to 261 billion euros of spending — which will propel its annual deficit to 12% and its total debt load to more than 160% of gross domestic product — would have potentially disastrous consequences, plunging the country back into a spiral of rising yields.
This may not be the time for the ECB to discuss increasing again the 1.85 trillion-euro PEPP, as there’s sufficient room to continue buying at this increased pace until the March 2022 program expiry. But there’s a perception in the markets that the governing council’s hawks don’t want to use the full envelope and cannot wait to start tapering, an ECB battle Draghi long fought and prevailed over.
The hawks mustn’t spoil the ship for a ha’porth of tar. Where Italy sails so does Europe.
Bloomberg
