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Updated 22:20 18/10/18

Bond yields soar as Italy stands behind budget promises

Liam Sheasby

By Liam Sheasby, News Editor

09 Oct 2018

Photo courtesy of the European Commission. Valdis Dombrovskis (left) and Pierre Moscovici (right) have criticised the Italian budget.

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The European Union and Italian government are at loggerheads after EU commissioners wrote to the Italian Finance Minister to criticise the recently agreed budget for missing targets.

The EU Commission believes that the new Italian coalition is in breach of the common rules for debt and deficit repayment, with Valdis Dombrovskis and Pierre Moscovici citing “significant deviation” from the 2019 budget targets expected of Italy.

Investor concern, and hesitance to back the Italian government, has seen bond yields rise drastically – the 10-year bond yield is now above 3.5% for the first time in more than four years, and the two-year bond yield is at a four-month high of 1.656%.

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Italy's Deputy Prime Ministers - Matteo Salvini of Lega (left), Luigi Di Maio of the Five Star Movement (right).

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The response from Rome was firm: we won’t change our mind. Luigi Di Maio, joint Deputy Prime Minister and leader of the Five Star Movement, was seemingly not fazed by the criticism of the budget, saying that other European nations will come to share Italy’s anti-austerity view.

The other joint Deputy PM, Matteo Salvini, was less restrained in his response. The leader of the Lega party was speaking at a press conference with Marine Le Pen, the French far-right leader, and said: “We are against the enemies of Europe -- Juncker and Moscovici -- shut away in the Brussels bunker. The politics of austerity of the last few years have increased Italian debt and impoverished Italy.”

Mr Salvini went on to suggest there was an element of conspiracy at work to undermine Italy’s political shift, following a huge widening of the gap between the Italian 10-year bonds and the German bonds yesterday. Salvini said: “If one had evil thoughts, he would think there are people betting on the spread because they don’t want Italy to grow and create jobs”.

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The bond rise is to be expected: Italy’s budget agreement involves more public spending, not less, at a time when Italy has a very large amount of debt and the European Central Bank are concerned that it may not be repaid. The Italian budget is not ignoring repayment (the suggestion is a slow 2019 for repayments then increase the rates in 2020/2021), but the ECB has no guarantees that Italy will honour this pledge. This breeds market fears, and in turn makes investors weary and less interested in backing Italian government bonds until the deal/yield is too good to resist, like now.

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Left: A Labour Party rally in Telford featuring leader Jeremy Corbyn. Right: The Five Star Movement rallying through the streets of Napoli.

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Italy’s new, anti-establishment regime has risen to power through opposition to austerity. Similar sentiments have been felt in places like the UK, where the Labour Party registered a far better performance in the last general election than expected, and unsurprisingly there are tensions between these nations and the EU, with many people seeing Brussels as the cause for their hardship. How true this is, who knows; it’s hard to objectively assess the impact of the European Commission and central banking regulations through the lens of our domestically-biased British press, but the worry is that the new Italian government will strictly adhere to the will of the people at all costs. This is democracy and shouldn't be ignored by the EU, but equally Italy has a responsibility to make tough decisions and to explain to the public why they are necessary. The debt cannot be ignored, even if Italy follow the UK into their own Euro exit, default on the debt like Greece, or leave the Euro (as recently hinted by Lega’s finance minister).

Jens Peter Sorensen, chief analyst at Danske Bank A/S, summed up the situation neatly: “The Italians are continuing to test the EU’s resolve. If neither the EU or Italy back down, yields will continue to climb higher from here, but I expect that Italy and the EU will find a compromise, even though it looks difficult at the moment.”

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The markets slumped in reaction to the EU’s message to Italy. The threat of a debt default still lingers, and the FTSE MIB lost 2.5% yesterday to reach its lowest level since April 2017. In contrast, German bonds and the Japanese Yen – both seen as safe haven assets – saw a surge in demand.

The Italian banks also suffered, with shares in Intesa Sanpaolo falling 3.8% and UniCredit losing 4% value. While Danske Bank, quoted above, believe that the EU and Italy will eventually reach a deal, not all financial firms share that belief. Martin van Vliet, a senior rates strategist at ING, told the Reuters news agency that they expected a clash between the two powers, adding: “Salvini is making crystal clear that they have no plans to go back to the drawing table.”

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Italy currently holds a Baa2 rating with the credit agency Moody’s, which equates to a BBB with the likes of S&P or Fitch. This is generally seen as a lower medium investment grade; a fair rating but one at risk. Any further slip will see Italy’s bonds classes as non-investment grade, or junk bonds.

The next update for Italy’s ratings will be at the end of October from both Moody’s and S&P – the latter confirming it will announce the results on October 26th. The outcomes will heavily depend on Italy presenting its full budget to the European Commission for review by Monday October 15th. If the EC are happy, then investors and creditors may look more favourably on the country, but if not we could see another gold price rise as investors buy bullion to diversify their safe haven assets beyond the Yen, Dollar, and German bonds and maximise the spread of their risk.

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