So much for Goldilocks.
Those expecting that Italy’s new government would work through the 2019 budget process without potentially setting itself up for a showdown with the European Union got a dose of reality on Thursday, as signs emerged of a struggle pitting the leaders of the ruling coalition’s two main parties against its independent-minded economy minister.
Italian government bonds sold off, sending yields jumping. On Friday, the yield on the 10-year Italian bond TMBMKIT-10Y, +10.17% soared 21 basis points to 3.11% after trading as high as 3.17%, according to FactSet. Stocks tumbled, with the FTSE MIB I945, -2.73% down 2.7%, while the euro EURUSD, -0.3951% dropped around 0.2% versus the dollar. Bond prices fall as yields rise.
Here’s what’s happening.
Targets
Italy’s government agreed to a 2019 deficit projection of 2.4% of gross domestic product, but the deal came after some intense internal wrangling.
In recent days, investors had been lulled into a sense of calm on news reports that leaders of Italy’s coalition government would go along with a 2019 deficit target of less than 2% of GDP. Economy Minister Giovanni Tria, who isn’t affiliated with either of the coalition’s main parties, had reportedly been calling for a 1.6% target, in keeping with the European Union’s budget rules.
But pushback by leaders of the antiestablishment 5 Star Movement and the far-right League, who want to increase spending to fulfill campaign promises on basic income, pensions and tax cuts, created turmoil. Italy’s La Stampa newspaper reported that Tria had at one point threatened to resign, though that was subsequently denied by the economy ministry, according to Reuters.
‘Collision course’
A 2.4% deficit could cause the total amount of public debt to raise again next year rather than fall, as currently projected, Federico Santi, analyst at Eurasia Group, in a note.
It would also put Italy on a “clear collision course” with the EU, he said, which would likely push back on the budget plans when Rome submits its draft proposal in October. It also risks an outright rejection of the budget plan by the European Commission and could also raise the risk of a one or more credit downgrades, which would add to pressure on Italian assets.
Perspective
Despite the drama, a Thursday auction of 10-year Italian bonds saw decent demand, noted Kathleen Brooks, research director at Capital Index, with the bid-to-cover ratio, a gauge of demand, rising to 1.44, representing the highest level since May, while the price Italy had to pay to attract investors fell, producing a yield of 2.9%, compared with 3.25% in the previous auction.
Brooks said the auction results suggest the market remains confident the budget proposals won’t anger the EU, the government won’t collapse, and that the proposals offer enough incentive to anti-EU parties, including tax cuts and pension pledges, it will quash threats of a U.K.-style referendum on EU membership.
“This budget will not be perfect, Italy’s centrist finance minister has bowed to populist pressure, and it remains to be seen how Italy can balance tax cuts with big spending plans, thus problems could arise in future,” she said.
For traders, however, an ability to pass a budget would mark the passage of an important test, which could be a positive for European assets.
“This is why the euro has backed away from earlier lows versus the dollar, and why Italian bond yields remain below 3%, nowhere near danger territory,” she said.
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