Adults in the Room Mean There's Value in Italy

(Bloomberg) -- Deep breath, but here goes. Italian government bonds might offer some value after widening more than 40 basis points to Germany over the last three weeks. There’s plenty of money sloshing around to lend support.

The Five-Star Movement and the League have produced a coalition agreement that takes another step toward introducing a populist government in the European core. The platform abandons some items that would have been truly frightening for investors, such as debt forgiveness. But what remains is still pretty scary. There’s a lot of fiscal expansion and no practical measures to pay for them. It’s a big bet on a lot of growth. 

The announcement sent the yield on the 10-year bond to the highest in 10 months. The benchmark FTSE MIB stock index lost 2.7 percent since Monday, making it the 87th worst performer out of 95 major global indexes, due in part to investor concern on Italian banks’ substantial exposure to government debt. Credit default swaps have jumped, though they’re still not at their highs for the year.

This isn’t quite the end game. Voters in both parties have to approve the new platform, and they should present it to President Sergio Mattarella early next week. They’ll also have to present their picks for prime minister and finance minister positions, two crucial positions, along with the rest of their cabinet. 

The president could well intervene. He looks like he wants to plan an active role — he is taking seriously his constitutional duty to ensure a workable government that can pass the 2019 budget this autumn. Any new fiscal policy is going to be heavily restrained by European Union rules on balanced budgets.

What isn't political noise is that 34 billion euros ($40.2 billion) of government debt, known as BTPs, mature this month — some of this has come, and there’s about 20.3 billion remaining. This will have to be reinvested. Though Italy has about 125 billion euros left in its debt issuance plans this year, this is more than covered by the 150 billion euros that matures.

Until at least September, the European Central Bank will buy about 4 billion euros of the securities every month through its quantitative easing program. There is flexibility to overbuy if needed, something it’s done occasionally over the last two years. The ECB is also locked to reinvesting its BTP holdings as they roll off quite a way into the future.

Italian 10-year yields have widened 50 basis points since mid-December to its closest European comparable, Spain, and the spread is now at a six-year high. What everyone wants to avoid is a bout of fiscal profligacy that gets investors into an absolute panic and sparks a showdown with the central bank.

Compared to Germany spreads are at the widest since January, at 157 basis points over 10-year bunds. That’s enough damage for now. 

For the last three years the BTP 10-year yield has shuttled between a low of 1.1 percent and a high of 2.4 percent -- which has held several times. At 2.19 percent currently it is near the high end of a well-established range.

Climbing borrowing costs undermine the prospect for Italy to be able to sustain its massive debt load. Were the ECB to allow the 10-year yield to break above its range, it would be a disaster — that would suggest to investors that there’s nothing to stop yields going all the way back up to where they were in 2013. All of the bank’s hard work to get the euro zone on a stable footing would have been for nothing. 

When ECB Vice President Vitor Constancio told Bloomberg Television officials are monitoring the spike in yields, you’d hardly expect him to say otherwise. But at least it shows that the bank is not entering the political fray and that it will continue to do its duty by continuing QE purchases as planned. 

The political heat may have some way to run. For one, Mattarella could reject the parties’ proposals. If so, the parties could then call for new elections. But once it subsides, Italy’s fixed-income punishment will probably look overdone. 

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