As skittish investors scan for the next trouble spot in the wake of Turkey’s currency dilemma, some market participants are turning a fresh eye to perennial market bugaboo—Italy.
The third-largest economy in the eurozone has resurfaced on investors’ radars as its populist government plans next year’s budget, which economists say are likely to expand fiscal deficits more than hoped, pitting the country against the fiscally conservative European Union.
Concerns over Italy’s fiscal road map have put local bank stocks and bonds under pressure, reviving talk of a dreaded “doom loop”, that is, the way in which Italian banks are dragged lowered by the deteriorating perception of its beleaguered government.
See: Here’s why Italy and financial markets are still headed for a showdown
“Italy should be the main focus as we enter the weekend with some pretty poor performance in their markets,” said Peter Boockvar, chief market analyst for the Bleakley Advisory Group, in a Friday note.
Investors are worried that Italy isn’t on a firm financial footing. That is, if, as discussed, lawmakers vote to remove the constitutional requirement that Rome maintains a balanced budget. Other policy measures floated that could strain government revenues include tweaks to controversial pension reforms and an introduction of a flat taxation system.
Those worries have combined to place pressure on Italian bond prices, which have fallen, lifting the yield for the 10-year government debt TMBMKIT-10Y, +0.25% by around 40 basis points since the beginning of the month to 3.132%. That marks its highest rate since May after populist parties formed a coalition government in Italy.
Bondholders are demanding richer compensation for holding risky Italian debt as the yield gap between Italian paper and relatively safer German government bonds TMBMKDE-10Y, -4.24% widened by 285 basis points, or 2.85 percentage points. Bond prices fall when yields rise and a widening gap between German paper and Italian sovereign debt has often been viewed as a sign of growing disenchantment with Italy’s financial outlook.
On top of that, data from the Bank of Italy shows net foreign outflows of Italian government debt rose to $33 billion in June, after $25 billion in May.
“With doubts about the quality of policy-making and even the government’s commitment to the euro, we suspect that this will help to push the 10-year [Italian bond] yield to 3.5% by the end of the year,” said Oliver Jones and Jack Allen, analysts at Capital Economics, in a Friday note. That could be mean worsening news for the Italian financial system.
Fretting over Italy’s budget or a rollback of pension reforms could prompt credit-rating firms to cut Italy’s sovereign debt rating by one notch, leaving it hovering above ‘junk’, a move that would spark further outflows from investors, analysts said. Receding into the ‘junk’ rating bucket would also make Italy ineligible for future asset purchases by the European Central Bank, which has been a backstop buyer of the country’s debt.
Moody’s Investors Service is placing Italy on review for a potential downgrade. A lower rating from a rating agency tends to translate to higher borrowing costs for the Italian government and corporations based in the southern European country.
Meanwhile, the FTSE MIB index FTSEMIBN, -0.53% is down 8.1% this month, led by the slump in Italian bank shares including Banca Monte dei Paschi BMPS, -4.72% and UniCredit UCG, -3.17% UCG, -3.17% FactSet data show.
Analysts say further weakness in Italian bonds could hurt an Italian financial sector still struggling to sell souring loans from years of anemic economic growth. Italian sovereign paper are the bedrock of their banks’ capital, especially as the ECB looks to end its asset purchases this year, said Nick Kounis, head of macro and financial markets research at ABN AMRO.
If a bond market slump stretches the balance sheets of Italian banks, they may be forced to raise cash by selling assets.
As of last June, Italian sovereign debt comprised around 145% of Tier 1 capital, a key gauge of a bank’s ability to absorb losses, in two of Italy’s biggest lenders, UniCredit SpA UCG, -0.48% and Intesa Sanpaolo ISP, -0.77% according to Eric Dor, director at IESEG School of Management.
The renewed attention on Italy comes as investors watch for contagion from the Turkish lira’s USDTRY, +3.2826% weakness, leading investors to take a dim look of countries with high debt loads, said Boockvar. The lira is down 37% against the U.S. dollar this year.
Moreover, European banks made extensive loans to Turkish corporations in euros as they offered better margins than lending to European firms which could borrow at ultralow interest rates. Though much of that lending originated from Spanish banks, Italian UniCredit is also exposed directly to the Turkish corporate sector as it owns 40% of Yapi Kredi Bankasi AS bank, a local subsidiary.
To be sure, Italian markets were veering toward trouble before the lira accelerated its slide.
“The spike that we saw in Italian yields and the reversal in the share price of Italian banks preceded the decline in the Turkish lira,” wrote David Owen, chief European economist for Jefferies.
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