By Stefano Bernabei
ROME (Reuters) – Italy’s 10-year government bond yield is forecast to average about 5% next year, close to its 2012 level during a dangerous debt crisis. Yet analysts say volatility more than yield will pose Rome’s toughest challenge in managing its debt mountain.
Italy’s overall 2022 debt level is estimated at 145% of gross domestic product, the second highest ratio in the euro zone after that of Greece. That compares with 116% in 2011, a ratio that many considered untenable at the time.
However, even though the Treasury will have to place 310-320 billion euros ($332-343 bln) of medium- and long-term BTP bonds this year with interest rates at historically high levels, economists are now relatively sanguine about the country’s debt sustainability.
The reason is inflation – which may hurt consumers and savers but is a boon for high-debt countries like Italy because it inflates revenues and GDP, making the debt proportionally smaller.
“In a world where you have 3% inflation, a 5% yield on BTPs is sustainable for Italy, because that inflation has a positive effect on the debt-to-GDP ratio,” said Philippe Gräub, Head of Global Fixed Income at Union Bancaire Privée (UBP).
So far this year BTPs have moved in sync with other euro zone government bonds and the gap, or “spread” compared with equivalent German Bunds has remained within what some analysts see as “safe zone” of 2 percentage points, or 200 basis points.
Bunds are seen by investors as the bloc’s safest bets.
The real problem for the Treasury is market volatility, analysts say. This has risen sharply in response to mixed messages from the European Central Bank over how high it will raise interest rates, and when they may come down again.
This makes it harder for Rome’s debt managers to forecast the so-called “yield curve”, which shows the yield on bonds of various maturities, from short-term to long-term.
ERRATIC SIGNPOSTING
The yield curve normally rises steadily as long term bonds yield more than short term ones, but recent factors – especially the ECB’s erratic signposting – have made it less predictable.
Other countries face the same volatility problem, but Italy is in the spotlight because of its huge outstanding debt of roughly 2.3 trillion euros.
“The most important issue for the next 12-24 months will be the shape and volatility of the yield curve, much more than the absolute level of yields,” said Filippo Mormando, European Sovereign & Rates Strategist at BBVA.
In recent months the ECB’s uncertain rhetoric has put bond markets on what Unicredit’s fixed income strategist Francesco Maria Di Bella called “a roller-coaster ride.”
The yield on the 10-year BTP plunged 40 basis points (bps) following the bank’s Feb. 2 policy meeting, before rising 15 bps the following day. A few years ago even a 5 bps point daily fluctuation on the BTP yield was considered large.
In the face of this uncertainty, Italy is aiming to lengthen debt maturity and boost bond purchases by retail investors, the Treasury’s debt management agency said in its strategic guidelines for 2023.
The ECB has driven up its key deposit rate from -0.5% to 2.5% since July, leading to a flattening of the curve as the yield on short-term bonds has increased, making them more attractive to some investors.
The bank has pencilled in another 50 bps hike for March, but what happens next remains highly uncertain.
MARKET ASSUMPTION
The consensus forecast is that the ECB will raise rates to 3.25% in its quest to tame inflation and then begin cutting them in the fourth quarter of this year, but numerous analysts are questioning this assumption.
“There is no reason for the ECB to cut rates before late 2024, as you may still have inflation at 2.5% in 2024 on average,” said Sylvain Broyer, Chief EMEA economist at S&P Global Ratings.
If Broyer is right, and markets push back their expectation for the ECB’s first rate cut to 2024 or even 2025, the yield curve is likely to flatten even more.
Should a 3-year bond yield as much as a 10-year one, the shorter maturity will become more attractive and the Treasury will have to adjust its issuance strategy to meet the demand.
An escalation of the war in Ukraine could increase volatility even more, analysts say, and diminish the appetite for risky Italian bonds even among traditional “real money” investment funds focused on long-term debt.
Against this uneasy backdrop, the Treasury will be able to rely less and less on bond purchases by the ECB, which last year ended its “quantitative easing” and emergency pandemic bond purchasing programme. The central bank maintains the backstop of its “transmission protection instrument” to support countries in the case of bond sell-off driven by market speculation.
Cristopher Dembrik, head of macro analysis at Saxo Bank, saw no prospect of a return to stability in the near term.
“There will be much more bond issuance this year and the market is wrongly pricing a cut in interest rates so I assume volatility will increase,” he said.
($1 = 0.9340 euros)
(Additional reporting by Antonella Cinelli, editing by Gavin Jones and Toby Chopra)
