Analysis: ECB faces Italian debt test as politics intervene

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Signage is seen outside the European Central Bank (ECB) building in Frankfurt, Germany, July 21, 2022. REUTERS/Wolfgang Rattay/File Photo

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  • Right-wing coalition leads in Italian polls as gaps widen
  • Anti-euro past and promises of tax cuts keep investors on edge
  • Markets to test ECB’s decision to buy bonds under new program
  • Smart money is unlikely to receive early intervention

FRANKFURT/ROME, July 27 (Reuters) – The European Central Bank looks all but certain it will have to test its resolve to contain excessive bond yields in the coming weeks as the euro zone’s biggest debtor, the Italy, is heading for an election that a right-wing bloc with a Eurosceptic past is expected to win.

The ECB, in a bid to cushion the impact of rising borrowing costs on Italy and other southern parts of the eurozone, said last week it would step in to support countries whose the debt is subject to market pressure through no fault of their own. Read more

As the interest premium that creditors are demanding from Italy rises again and the country suffers a downgrade to the S&P debt outlook, expectations for ECB action look set to rise as that the electoral campaign is heating up and that investors are putting a price on the economic promises of the radical parties.

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But the bank also said it would only buy a country’s debt “to counter unwarranted and disorderly market dynamics” and if that country abides by EU economic protocols, including one to control public debt. .

It defines the leeway that ECB President Christine Lagarde and her colleagues on the Governing Council have deliberately allowed themselves – and suggests that any bet on early intervention by the bank could fail.

Italy’s debt-to-GDP ratio relative to the rest of the periphery; GDP per capita in the main euro area countries

MORE SAFE HANDS?

The collapse last week of the government of Mario Draghi – widely seen at home and abroad as a pair of safe hands – has dampened hopes of economic recovery in a country where low growth and high debt are rooted for years. Read more

Market nerves have been further rattled by polls predicting it will be replaced on September 25 by a conservative bloc comprising a far-right party and two that have promised deep tax cuts and were openly Eurosceptic there. a few years ago.

Ratings agency S&P Global downgraded its outlook on Monday amid concerns the country may meet European Union conditions for nearly 200 billion euros in pandemic stimulus funds, which could prove vital in a context of likely recession this winter. Read more

The closely watched spread between Italian and German 10-year bond yields fell to 248 on Wednesday, just slightly below the peak reached in June when the ECB accelerated work on the new bond-buying program, known under the name of transmission protection instrument. (TPI). Read more

Bank of Italy’s Ignazio Visco said the current risk premium is much higher than warranted and blamed political uncertainty for it. Read more

But he will have to convince his colleagues on the Governing Council, including Bundesbank President Joachim Nagel, who has said the TPI should only be used “in exceptional situations” – and any routs in the Italian market driven by election promises. could arguably be considered self-inflicted harm.

“We suspect the ECB’s willingness to intervene in bond markets will be tested sooner rather than later,” said Jonas Goltermann, an economist at Capital Economics.

This test has kind of already started, but many analysts don’t expect the ECB to intervene until the Italian/German spread hits 300 basis points or more.

“I would be very surprised if the ECB intervened below 300,” said Jens Eisenschmidt, an economist at Morgan Stanley. “They will want to err on the side of caution in terms of what can be considered justified.”

Spread between Italian and German 10-year bond yields

TAX GAP

The leading right-wing coalition in the polls has yet to unveil its manifesto.

Its two largest parties, Giorgia Meloni’s far-right Italian Brothers and Matteo Salvini’s League may have abandoned the anti-euro rhetoric of the past decade.

But they promised tax cuts of up to tens of billions of euros, without specifying how these would be offset other than by restricting access to a basic income scheme, which should only cover a small part of the budget gap.

All parties in the coalition, which also includes Silvio Berlusconi’s Forza Italia, have also been lukewarm about updating land values ​​in Italy’s land registry, a reform recommended by the European Commission but which would likely result in higher taxes for millions of people.

This could put Italy on a collision course with the EU – and therefore investors – even before the election.

“Investors would rationally demand higher risk premia, and the ECB should let it happen,” said Lorenzo Codogno, head of LC Macro Advisers and a former Italian treasury official.

He did exactly that when a radical government backed by the League and the Five Star Movement took office in 2018, scaring investors into talk of large deficits and confrontations with Brussels.

At the time, Rome backed down. This time, the prospect of losing EU funding worth 7.6% of GDP might give the successor government reason enough to do the same.

In the meantime, the ECB has made it clear that it retains the final say on any intervention in the TPI market – a substantial difference from the ECB’s previous emergency regime, known as monetary transactions in securities. .

Unveiled by Draghi in 2012 when he headed the ECB after his famous promise to do “whatever it takes” to save the euro, the OMT could only be activated if a country requested an official bailout, which meant that it was ultimately never used.

“(TPI) could work because the conditions are lighter than with previous programs and the size is unlimited,” said Carsten Brzeski, economist at ING.

“It may not be a tool of everything we need, but rather a tool of everything we want.”

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edited by John Stonestreet

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