Berlusconi's Shadow Looms Over Italian Bonds

(Bloomberg) -- Political turmoil is rarely a good backdrop for Italian bonds.

This time seems different. An auction of government debt on Friday showed investors had little inclination to demand higher borrowing costs to offset the risks around the prospect of a populist, anti-immigration government of the Five Star Movement and the League.

This shows the strength of the European Central Bank’s firepower. It already owns 340 billion euros ($405.7 billion) of Italian government bonds, commonly known as BTPs, in its current QE program. The bank has swallowed up all net new Italian issuance since it started purchases in 2015.

The good times are far from over. While the flow of QE will probably come to a halt at the end of this year, the stock of existing purchases will remain, and the ECB will continue to reinvest maturing holdings. And in the short term, the 13.6 billion euros of debt maturing next week, and the further slug of 20.3 billion euros at the end of May, will keep cash flowing into the market. 

This explains why Friday’s regular auction of three, seven and 15-year maturities went off without a hitch. Similarly, a eight-year BTP Italia bond aimed at retail investors should see decent demand when it launches next week. And the raft of supply due over the remainder of the year shouldn’t weigh on the market — Italy is about halfway through its planned 225 billion-euro issuance program this year, but there are nearly 150 billion of coupons and maturing bonds still to roll off. 

That is why Italian yields have been able to tighten steadily to Germany from a high of over 200 basis points a year ago to 135 basis points now. It’s not a clean win, given that the improvement isn’t as vigorous as for Portugal or Spain. A widening of 20 basis points in the last three weeks is certainly justified, and more may well be due. But the ECB is not backing away from this fight. It has the flexibility to overbuy — as it has steadily over the past two years for BTPs.

The country’s recent history looms large over the market. Silvio Berlusconi’s attempt to deviate from budget discipline in 2011 did not end well for investors. The central bank pretty much refused to buy the country’s debt unless the government came back into line, which as a practical matter meant Berlusconi had to go. The installation of Mario Monti’s technocratic government shows who won. 

While nothing is assured in Italian politics, a union of the hard right and anarchists seems to be on its way. The one area both parties agree on is fiscal expansion to revive growth, and whatever pushback against European Union fiscal rules would be needed to achieve that.

As long as any new Italian government keeps its anti-establishment sentiments to itself and doesn’t stray too far from the bloc’s rules, the central bank should be able to continue purchases, and that should keep a lid on yields. Five Star’s Luigi Di Maio and the League’s Matteo Salvini have toned down their anti-EU sentiment in recent months. Italian yields are betting that they’ll largely continue to sing Brussels’ and Frankfurt’s tune.

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