Euro Steady but Looming Italian Budget Row Risks Breach of Bond and Currency Market Peace

-August, September see Italian finances under spotlight once again. 

-Budget risks showdown with Brussels and bond market pandemonium.

-Italy-Germany bond spread is best gauge of market's budget anxiety.

© European Union - European Parliament, reproduced under Creative Commons licensing

The Euro was steady against the Dollar Wednesday but the currency will be increasingly vulnerable to losses over coming weeks as the new Italian government thrashes out its 2019 budget plan ahead of a possible showdown with EU fiscal hawks in Brussels toward the end of the year. 

Italy's government ministers and party chiefs are expected to draft their budget plan for next year over the course of August and September, before submitting it to the European Commission for approval in time for an October 15 deadline. The European Commission will then deliver its verdict on the budget plans by no later than the end of November. 

"There is a good argument to be made that the rise in support for the far-right League in Italy will encourage the party to take a robust approach to framing the 2019 budget proposal due in September, setting the scene for a direct standoff with Brussels and Frankfurt later this year," says Simon Derrick, chief currency strategist at BNY Mellon. 

Both Five Star Movement (M5S) and League parties, which are now in coalition together, have at various points in the past advocated referendums on Italy's continued use of the Euro. Although since being elected they have, albeit unconvincingly, made efforts to assuage market concerns over their commitment to the single currency.

The two anit-establishment parties won office in the March 2018 election after pledging to increase public spending and roll back a series of crisis-era reforms that have been credited with pulling Italy back from the brink of a debt crisis but that, at the same time, have seen painful austerity measures imposed on the population.

Fears are that an Italian clash with Brussels over public spending plans would lead to even greater anti-Euro sentiment in Italy and potentially endanger the nation's place as a member of the single currency bloc.

"As the radicals now ruling Italy have promised their voters to raise spending, cut taxes, reduce the retirement age and reverse some pro-growth reforms, an Italian debt crisis could become an accident waiting to happen," says Holger Schmeiding, chief economist at Berenberg Bank. "The issues could come to a head in the next ten weeks as Italy prepares its draft budget for 2019."

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Unstoppable Force Meets Immovable Fiscal Wall 

Italian public spending is a hot button issue because the Mediterranean nation is subject to a European Commission "Excessive Deficit Procedure" for being in breach of fiscal rules set out in the Maastricht Treaty. Maastricht's Stability and Growth Pact forbids budget deficits in excess of 3% of GDP and national debt over 60% of GDP.

Excessive deficit procedures, which were strengthened by the "Two Pack" and "Six Pack" regulations following the Eurozone debt crisis of 2011, are mandatory when either of these thresholds are breached and give the European Commission far-reaching powers to make demands of national government fiscal policies.

Italy's budget deficit fell to 2.3% of GDP during 2017, from 2.5% back in 2016, but its national debt pile of €2.4 trillion is still in excess of 130% of GDP. This means Italy is legally bound to implement Brussels' demands for action on the public finances.

But any such demands are almost certain to be at odds with the new government's policy platform of, among other things, a "basic income" for the poor, the introduction of a single flat tax rate, abandoning planned increases in VAT sales taxes and reversing earlier pension reforms. 

"Our base case remains that the Italian government will rein in its most pricey fiscal plans and muddle through somewhat noisily without a dramatic crisis for the time being. For the next ten weeks, we project significant noise with occasional bouts of market anxiety. To some extent, wider yield spreads may force the radicals to tone down their plans. Still, the risk that careless behaviour in Rome could soon trigger an Italian crisis is not negligible," Schmeiding adds.

Iceberg Hits: Reforms the Only Lifeboat

2011 reforms abandoned the generous defined benefit pension system, reduced levels of inflation protection for retirees, raised the retirement age from to 67 and made sharp increases to the number of years worth of contributions that must be made for in order to qualify for a state pension.

These measures were implemented by the technocratic government of Mario Monte, a former European Commissioner, and were seen in Brussels as a milestone moment in efforts to make Italy's public finances more sustainable.

Monte had been voted into office by lawmakers following the 2011 resignation of Silvio Berlusconi, despite his government containing no party representatives or elected politicians. The only party to oppose the appointment at the time was League, operating under the name League Nord.

"The most direct barometer of these renewed tensions remains the spreads between Italian bond (BTP) and bund yields, with all the main tenors starting to blow out once again in recent days to not far short of where they reached in mid-June," says BNY's Derrick. 

The difference in yield demanded by investors who hold Italian and German government bonds is seen as the best measure of market anxiety about Italian politics, given German bonds are seen as a European safe-haven asset and so offer the lowest yield. In other words, German borrowing costs are lowest because the central European country is seen as a safer investment for creditors. 

The Bond Market is Watching

Wednesday, the "spread" between 10 year yields of Italian and German government bonds was around 260 basis points, or 2.6%. A rising spread would likely be the result of an increase in Italian borrowing costs and would risk seeing future debt interest payments grow larger, placing even further unmanageable demands on the public purse. 

"Considering fundamentals and positioning, we think the current level in 10y BTP-Bund spreads (260bp) is transitory: by December, we expect 10y BTPs either to tighten toward 170bp against Bunds or shoot toward 400bp. Putting aside external shocks (like the materialization of trade-war risks) for now, the direction of the spread will likely depend on how the credit rating agencies receive the proposed 2019 budget," says Erjon Satko, a bond market strategist at Bank of America Merrill Lynch. 

Many Southern European countries saw their 10 year government bond yields rise above 6% during the debt crisis years, which was a level that European and International Monetary Fund officials judged to be unsustainable for nations that are carrying such high debt burdens. 

Given the extent to which national debts have risen since 2011, the level at which yields become unsustainable could well be lower this time around. And Bank of America estimates the spread between Italian and German bond yields could reach 4% later this year, which would require an increase to 4.4% for Italian 10 year yields. 

"The political debate about Italy’s 2019 budget still seems to be in its early stages. Various ideas as to which promises should be kept to which extent are floating around in the press," says Berenberg's Schmeiding. "It is too early to predict the outcome of the negotiations with any confidence."

Any spike in market anxiety about Italian financial stability would be sure to place fresh downward pressure on the Euro during the months ahead. 

The Euro-to-Dollar rate was quoted 0.05% lower at 1.1597 Wednesday and was down by a total 3.2% for the 2018 year-to-date. 

"Our core scenario remains for a gradual introduction of the governing coalition’s budget reforms (Lega’s flat tax and M5S’s universal basic income) over the next few years, with some policy elements watered down, or left out entirely. The Commission will also see the merit in compromising with Italy to avoid the risk of stoking anti-euro sentiment," says Christopher Graham, an economist at Standard Chartered. "We cannot rule out early elections or ECB support to counter significant market disturbances, but these remain tail risks for now."

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