Italian Bonds Rally to Shrug Off EU Verdict on Hope for Dialogue

(Bloomberg) -- Italy’s markets shrugged off the European Union’s first step toward imposing fines on the nation over its budget on hope there might still be room for dialogue.

Ten-year bond yields stayed on course for the biggest drop this month and bank stocks gained as the European Commission’s censure had already been priced in by investors. The debt extended an early rally that came on reports Deputy Prime Minister Matteo Salvini may be open to spending revisions to avoid punishment.

Italian Bonds Rally to Shrug Off EU Verdict on Hope for Dialogue

The rebuke by the EU, which said Italy’s budget was in serious non-compliance with its fiscal rules, had been expected by markets after Italy’s populist government had refused to adjust its budget. Salvini said he won’t compromise on core items such as tax cuts and a basic income for the poorest, but is willing to make tweaks and is open to dialogue.

If “some sort of compromise is found, sanctions may even be avoided, which would make it likely indeed that the BTP-bund spread retightens back to the 250-275 area,” said Martin van Vliet, senior interest-rate strategist at ING Groep NV.

Italy’s 10-year bond yields fell 12 basis points to 3.50 percent, having whipsawed earlier on conflicting headlines from Rome. Yields touched 3.72 percent Tuesday, the highest level since Oct. 19. The spread over those on their German peers narrowed to 313 basis points.

The euro advanced 0.3 percent to $1.1403, as its correlation with Italian bond moves increased. Italy’s FTSE MIB Index pared early gains, but was still up 0.8 percent to snap five days of losses. Banks outperformed and the FTSE Italia All-Share Banks Index climbed 2.1 percent.

Italy’s markets have been pressured by the standoff with the EU in recent weeks. Its economy, the euro-area’s third largest, has a debt-to-GDP ratio of 130 percent, second only to Greece, while its rate of growth lags most nations within the bloc. The Commission said the budget was a “particularly serious case of non-compliance.”

“The positive for the market here is the likely relief that the EU has been relatively neutral in its language,” said Peter Chatwell, head of European rates strategy at Mizuho International Plc in London.

If the EU follows through with sanctions, it could levy fines of 0.2 percent of Italy’s gross domestic product, which could increase to 0.5 percent if the government in Rome doesn’t amend the budget. It would also mark the first time the bloc has levied fines on a member nation.

Despite Wednesday’s debt rebound, some of Italy’s most loyal bond buyers are showing signs of desertion. A sale of inflation-linked debt, popular with retail investors, garnered just a fifth of the orders by its second day compared to the previous sale in May.

“The question is whether investors think there is sufficient yield premium to compensate for the ongoing stress this will likely pass into the Italian real economy, and whether this drag will be the eventual cause of a change of tack from the government,” Chatwell said.

©2018 Bloomberg L.P.