Volatility will shake up Italian government bonds

Italian BTPS: divided between covid, inflation, and political pressures.

Currently, three elements are driving BTPS performance:

1. New covid wave
2. ECB support
3. Political backdrop

The new covid wave and the lack of hard scientific evidence concerning the omicron variant are prevalently driving European long-term yields. Bonds are sticking to the idea that further restrictions will hinder economic growth, compressing yields. However, we expect this to be a temporary distortion that will solve as fears concerning the new variant ease, and we get towards spring.

More concerning are instead the forces that continue to put upward pressure on yields.

Investors are increasingly worried about fading ECB support, and we believe that these fears are not unfounded. Inflation in the eurozone recently rose to 4.9% YoY, the highest on record since the introduction of the euro currency. Italy's CPI soared to 4% YoY, while the country's monthly PPI index hit 7.1% in November.

Policymakers are increasingly worried that inflationary pressures will be stickier, especially since supply chain bottlenecks appear unlikely to resolve until 2023. Within this context, it's doubtful that the ECB's monetary policies will remain accommodative for longer, posing a threat to all countries that depend heavily on its support, such as Italy. The central bank intends to end the PEPP program in March, as announced in the summer, worrying BTPS holders. The biggest beneficiaries of the PEPP program have been Italian and Greek government bonds. Without an eligible substitute, yields will soar quickly.

However, the imminent problem is how the ECB is going to deal with the announcement of the end of the PEPP program in December. Suppose it doesn't decide on any enhancement concerning existing asset purchases programs. In that case, the periphery, particularly Italian BTPS, is likely to throw a tantrum. The longer the central bank wait to relax other facilities’ rules (such as the ones for the APP) or introduce a new purchasing program, the less likely it is for policymakers to see scope to support bond purchases amid sustained inflationary forces, putting more pressure on BTPS.

Within this context, the spike in 2-year BTPS makes sense.

Lastly, the political backdrop adds to investors' worries. Since Draghi entered the political scene, it has been a smooth ride. However, now that president Mattarella is to leave the Quirinale in January, political parties are trying to push the former head of the ECB to take this role. That would be a gamechanger for Italian politics because the President will need to appoint a new technical government or call an early election. The problem with this notion is that Draghi is an essential figure when it comes to the country’s relationship with the EU. The Italian economic recovery depends on European financing. With Draghi, Italy has the certainty that the money of the NextGenertionEU fund will be spent according to plans and that the necessary reforms will be implemented. This way, Europe will continue to finance the recovery. Without Draghi, the country faces the risk of a fractured political system, risking that anti-European parties will come at play again, threatening the country’s international credibility.

By focusing on the omicron outbreak, the market is underplaying this political risk, which may play out in just a few weeks.

Italian yield curve: bear-flatter first to bear-steepen later.

The above means that Italian yields are poised to rise, and the BTP-Bund spread to widen. While covid distortions will continue to keep yields in check, they will accelerate their rise once this cap is removed.

We expect to see Italian yields higher across the curve in the upcoming months. However,  the most imminent risk is for the front part of the yield curve to spike if the ECB doesn’t tread carefully its message surrounding the ECB. In the meantime, the long part of the yield curve will remain in check amid a new wave of covid.

In case of political turmoil, long-term yields will rise despite covid news. Yet, if Draghi remains as premier, it's likely we won't see yields soaring until fears concerning covid are eased. Yet, as a new wave of Covid comes to an end with the PEPP program, it will be unavoidable to see the long part of the yield curve adjusting higher with 10-year yields rising to 1.3%.

As a consequence, we'll see the BTPS-Bund spread widening, although at a slower pace. Higher BTPS will be accompanied by higher Bund yields touching a maximum of 150bps before resuming its long-trend tightening. Indeed, we remain constructive BTPS in the long term as we see the new German government working towards better European integration.