The ECB Must Stop the Rot in Italian Bonds

(Bloomberg Opinion) -- “Whatever it takes.” Those three symbolic words were uttered by European Central Bank President Mario Draghi in July 2012, and European bonds have benefited hugely from the “Draghi put” ever since.

Italy has revived existential questions about the bloc. The latest twist in this drama looks to be the agreement between the Five Star Movement and the League on a prime minister, and the prospect that President Sergio Mattarella will approve the selection, putting the coalition one step closer to actually governing. While the parties’ platform has had some seriously euroskeptic elements expunged, a decent share of it contravenes European Union rules on fiscal prudence. Investors are right to be worried.

The ECB’s commitment to Draghi’s pledge faces a big test. The bank can easily use its plentiful firepower to halt the selloff in Italian bonds, and it had better make sure that it does. And soon.

Italian 10-year yields are back near highs seen last summer, and it’s a logical level for the central bank to defend. As I have argued, were yields to breach 2.4 percent, investors would be absolutely justified in believing that the Draghi put has died. This would be a recipe for all of the bank’s hard work to drive down borrowing costs for the region’s most-fragile members to unravel. 

That’s not the only security to worry about. The near-50 basis point jump in two-year yields, to the highest in two and a half years, will create a serious drag for the domestic economy and for the banking system, neither of which have fully recovered from the financial crisis.

There’s plenty of reason to think that the worst elements of the coalition platform won’t make it through. This populist administration will be heavily boxed in. With a small majority in the senate, it will struggle to see most, if any, of its grand plans pass into law.

Even if any of it does pass, President Mattarella has power to veto any legislation that breaches the constitution. Similarly, the European Commission is sure to do whatever it can to keep Italy from deviating from the bloc’s rules and the previous government’s targets for achieving fiscal sustainability.

Mattarella has yet to award any new government a mandate. He is perfectly within his constitutional rights to reject unsuitable candidates. To that end, a prime minister that is not seen as a puppet to the populist parties — and a respected finance minister without euroskeptical views — could go a long way to reassure markets. 

However, the cost of pushback here could be substantial. Five Star’s Luigi Di Maio and League’s Matteo Salvini have said they’d seek new elections were the president to create too great an obstacle to their preferred administration. 

More to the point, the surge in yields suggests investors are increasingly unwilling to bet that all these institutional barriers will be enough to stop Italy from tipping over into fiscal mayhem. 

The ECB has been loud and clear that its mandate is to preserve the euro. It did the right thing after the Italian government was defeated at the 2016 constitutional referendum — yields barely budged on the result, and that was surely down to the bank’s steady presence.

It has plenty of flexibility to intervene now, and a spot of overbuying of government bonds through its quantitative easing program wouldn’t go amiss. This would be a whole lot better than delaying action to the point that yields break the 2.4 percent barrier and the bank loses its ability to control the market. 

As Draghi said almost six years ago, if rising sovereign debt yields undermine the impact of monetary policy, then it’s within the ECB’s remit to address them. Time to put action to those fine words.

©2018 Bloomberg L.P.

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