Global Daily – Italy debt scenarios and spreads

by: Nick Kounis , Aline Schuiling , Bill Diviney

Euro Rates: Italy spreads would shoot well-above 200bp if fiscal plans are largely implemented – After the sell-off of the last few days, Italian government bonds rallied on Tuesday. The spread had approached the higher end of the 100bp-200bp rough range that we have seen during the QE era, and perhaps investors started to find the compensation attractive. In addition, there were hopes that President Sergio Mattarella would take up a more assertive and active role in restraining the policies of the incoming populist coalition government. For now, it seems that Italian government bonds will settle in the upper end of their QE era range, consistent with the heightened credit risk, until there is more clarity about the likely extent of the fiscal deterioration. Indeed, this is highly uncertain. We assessed the outlook for government debt under different scenarios for the fiscal package that is implemented (see details below). The conclusion is that a net fiscal deterioration in excess of 1% GDP (stimulus measures minus offsetting consolidation) would lead to a sharp rise in the government debt ratio from already high levels. In this scenario, we would think that spreads – despite the depressing impact of the central bank’s large portfolio of Italian bond holdings – would rise well above the 200bp level. Only in a more benign scenario of a net fiscal deterioration of around 1% GDP may we see spreads remaining within the current range. So clearly, risks are to the upside to current spread levels. (Nick Kounis & Aline Schuiling)

Euro Macro: Three scenarios for Italy’s debt ratio – Italy’s two populist parties seem very close to finalizing a new government, although they do still need the approval from President Mattarella. The policy agreement of the two parties that was published late last week holds a wide variety of policy measures, most of which were part of their respective election programmes and have been widely discussed before. Various estimates of the financial consequences of the stimulus package, if fully implemented, suggest that the total costs could mount to around EUR 100bn (around 6% of GDP). However, we think it is very unlikely that this stimulus package will be implemented in full without any offsetting deficit reducing policy measures. Indeed, the parties have mentioned that they plan to implement measures that would limit the total fiscal stimulus by cutting government spending and lifting government revenue, but they have not specified these measures. Moreover, president Mattarella would probably not accept a government that would immediately jeopardise Italy’s financial stability.

In order to calculate what the impact of the next government on Italy’s government debt would be, we have calculated three different scenarios. In all scenarios we have assumed that the Five Star Movement (M5S) and Lega Nord (LN) will fully implement their two signature policy measures, which is a flat tax of two tariffs (15% and 20%) for LN and a guaranteed income of EUR 780bn per month for M5S. The total costs of these two measures are estimated to be around EUR 70bn, which is equal to around 4% of GDP. In the first scenario for government debt we have assumed that no offsetting budget deficit reducing measures will be introduced. Other things being equal, the government debt ratio would mount to around 180% GDP in 2030 (up from around 132% in 2017). In the second scenario we have assumed that compensating measures to an amount of around 1% GDP will be implemented, meaning that the net fiscal stimulus would be roughly equal to 3% GDP. In that case, the debt ratio would increase to around 165% GDP in 2030. Finally, in the third scenario we have assumed that the net fiscal stimulus is only 1%, in which case the debt ratio rises modestly to around 140% GDP. (Nick Kounis & Aline Schuiling)

US Rates – What does the yield curve tell us about neutral? While the 2s10s yield curve has stabilised in recent weeks around the 50bp level, amid a breakout in the 10y above 3%, Fed policymakers have if anything expressed even greater concern about the flattening trend in recent public commentary. For instance, Dallas Fed President Kaplan said last week that the Fed should avoid ‘knowingly’ inverting the yield curve, while Atlanta Fed President Bostic went as far as to say it was his ‘job to make sure that [yield curve inversion] doesn’t happen’. In our note published today on the neutral rate, we found that there is a remarkably strong relationship between the yield curve and the spread between the Fed funds rate and neutral rate estimates, but the current 2s10s level suggests neutral could well be lower than many estimates suggest. While there could be other explanations for a flatter yield curve – for instance, the structural decline in term premium – Fed policymakers are right to be vigilant as it is a sign of tightening financial conditions. We expect the flattening in the yield curve to resume over the coming quarters, as higher expectations for Fed rate hikes outpace the rise in the 10y yield, but we do not foresee an outright inversion until the second half of 2019. (Bill Diviney)