Italy government bond update

Following the resignation of Italy’s Prime Minister Mario Draghi and the European Central Bank (ECB)’s 50 bp rate hike on 21 July, the 10-year Italian government bond yield rose to 3.55%, with its spread vs. the German Bund reaching 232 bp.

We expect Italian Buoni Poliennali del Tesoro (BTP) spreads to remain volatile and particularly vulnerable to Italian political risks, as snap elections are held on 25 September. Key for investors will be the thorough implementation of the National Recovery and Resilience Plan (NRRP), which is necessary to receive the next tranches of the Recovery and Resilience Facility (RRF).

The ECB has delivered on its part by setting up a new Transmission Protection Instrument (TPI). Although the ECB is unlikely to cap BTP spreads should snap elections trigger a political crisis, the fact that the TPI is unlimited, unanimously agreed and at ECB’s full discretion should still provide a backstop. It will prove useless however if the new government jeopardises Italy’s eligibility for the TPI.

In our central scenario we would expect the 10-year BTP spread to hover around 250 bp in the coming months due to political uncertainty with risks of larger rises. Our year-end forecast stands at 200 bp as we expect the next government to still receive fiscal support from the European Commission (EC) and monetary support from the ECB. Given upside risks on 10-year BTP yields we remain underweight euro periphery government bonds.

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