Yield Curve Flattening to Pause
It’s been nearly five months since the Italian general elections, with the result and the process of forming a coalition government eventually leading to the steepest selloff in BTPs we’ve seen for a long time, and the spread to bunds touching levels not seen since 2013. At the time there was uncertainty about the new coalition’s intentions regarding Italy’s euro membership and, to make matters worse, President Mattarella refused the first proposed government when he vetoed the appointment of a Eurosceptic finance minister. In the aftermath, markets quickly priced in the probability of a new election, and the possibility of the Eurosceptic parties gaining an even larger share of the vote.
So what has happened since then? We now have new information on at least two important topics. Firstly, the government is now in place and markets have had the chance to review some of the policies they actually plan on enacting. These include a pension reform, some labour market reforms and a flat tax structure, among others. Some of these policies will not be well received in Brussels (if they actually make it through parliament) so we expect to see headlines about the Italian government clashing with the EU over these. Secondly, market participants have had time to consider the probability of Italy leaving the Eurozone. In this regard the latest polls (published July 9) are very clear, with over 65% of Italians saying they do not want a referendum on membership and just over 74% saying they would vote to stay in the euro if there was one. For us, these numbers suggest the probability of Italy leaving the Eurozone is close to zero.
Based on this new information, where should BTPs be trading? What we now have is a weak coalition government, formed by parties that disagree on a number of issues, which will try to pass legislation that will be challenged by the EU. Spreads should therefore be wider than pre-election levels. However, there is no real threat at the moment of Italy leaving the Eurozone, and yet the two-year BTP is still yielding over 70bp. To put this in context, the two-year Portuguese government bond yield is minus 20bp and the equivalent Spanish bond yields minus 33bp – just to confirm, out of the three countries, the G7 nation is Italy.
Looking further out the curve, the 10-year Italian government bond yields 2.7%, which is closer to the Greek 10-year yield than it is to the Spanish!
It does seem reasonable that a newly elected, non-market friendly government should translate into a premium in yields, but the current spread to other peripheral countries seems unjustified and we would expect this to compress going forward.