Bond market heats up amid ECB tightening and political divide

The Italian Air Force aerobatic unit spreads smoke in the colors of the Italian flag over the city of Rome.

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A possible Italian presidential election result may have avoided political instability for now, but market watchers are wary of the economic and political future of Europe’s third-largest economy.

The yield on Italy’s 10-year government bond traded at 1.8680% late Tuesday afternoon, up around 5 basis points and building on gains seen on Monday . The benchmark bond’s rate is at its highest since April 2020, meaning the Italian government now faces higher costs when raising funds in public markets – which could ultimately become a bust. economic head for Rome.

“The peripheral bond market must adapt to the reality of a world without ECB QE [quantitative easing]“said Frederik Ducrozet, strategist at Pictet Wealth Management, in a note to clients on Tuesday.

One of the reasons for this week’s moves in European debt markets is the heightened expectation that the European Central Bank will tighten monetary policy in 2022, with a possible rate hike later this year. Any rate hike would be the first since 2011, when the bank was criticized for acting too soon at a time of great financial stress.

The 19-nation euro zone, of which Italy is a member, has seen loose monetary policy since the 2011 sovereign debt crisis with billions pumped into its economy to boost lending and stimulate economic activity. As the region’s outlook started to improve in 2019, it was then hit by the coronavirus pandemic and the ECB subsequently launched a new bond-buying program.

This included buying even more eurozone government bonds, so nations would face lower costs when raising new debt.

“In 2020-21, the Bank of Italy bought more than 100% of the net supply of Italian central government debt. In 2022, we estimate that the central bank will buy up to 60% of the issue In 2023, this source of demand will disappear,” Ducrozet said, highlighting the changing monetary policy landscape.

As a result, he added, “Growth and fiscal prospects will be key” for Italy.

Political fragmentation

An additional problem for Italy is its parliament, which often experiences huge political fragmentation, impacting its growth and fiscal prospects.

It’s “clear that party leaders don’t have strong control over their parties. That’s what makes me nervous,” Gilles Moec, chief group economist at AXA Investment Managers, told CNBC on Monday.

Indeed, political fragmentation is so acute right now that lawmakers have recently tried eight times to elect a new president. After nearly a week of inconclusive votes, lawmakers have decided to ask Sergio Mattarella to continue as the country’s president, despite wanting to step down.

“The Mattarella-Draghi duo can provide short-term support, but Italy’s medium-to-long-term outlook remains highly uncertain,” Wolfango Piccoli, co-chairman of consultancy Teneo, said in a note to clients this week. last.

Italian President Sergio Mattarella arrives with Italian Prime Minister Mario Draghi.

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Mario Draghi, who has served as the country’s prime minister for a year, has brought stability to the nation. He has drawn up a plan on how to invest nearly 200 billion euros ($228.6 billion) in European pandemic recovery funds while retaining support from major political parties.

However, Draghi’s term ends in the spring of 2023 – when new parliamentary elections are scheduled.

There are now key questions about whether Draghi, a former ECB president, will manage to continue implementing much-needed reforms before the end of his term. Political parties will soon begin to prepare the ground for their election campaigns and, more broadly, an election will undoubtedly bring uncertainty about the type of coalition that will emerge after the vote.

“While stronger leadership from Draghi is a necessary condition to keep the demons of Italian politics in check, it is not enough to keep the country on track over time,” Piccoli said.

Italy “is not a country the EU can do without”

Opinion polls project a deeply divided parliament in Rome following next year’s election. The centre-left Partito Democratico and the far-right Fratelli d’Italia have the same support in the current polls, at around 21%. The anti-immigration Lega party follows with 18% of the vote, and the leftist Five Star Movement ranks fourth with around 14% of support. That’s according to data collected by Politico.

This suggests that the next election will be a very close race and that different coalition formats are possible. Investors will be interested to know what the chances are of Rome continuing to implement the economic reforms needed to receive the massive European stimulus funds, which will be essential to boost Italy’s economy.

“The markets will be very alert to this,” said Gilles Moec of AXA Investment Managers.

However, the level of commitment of some parties to implement the reforms Draghi agreed with the EU is unclear.

“Well, I don’t see why (Italy’s economy should be in jeopardy),” Francesco Lollobrigida, parliamentary leader of the Brethren of Italy told CNBC in Rome, when asked if his party understood the risks. economic not to reform.

“Italy is not a country that the EU can do without. A strong Italy is also useful for a strong Europe. The two things must therefore be done in parallel,” he said.

Europe’s massive recovery plan is heavily dependent on Italy. Indeed, Rome receives the highest amount than any other EU country under this scheme. The inability to reform and obtain these funds would call into question the effectiveness of Europe in the implementation of its objectives.

–CNBC’s Anita Riotta contributed to this article.

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