Head of Fixed Income Strategy
While much attention has been given to the narrowing spread between Italian BTPs and French OATs amid political turbulence, investors should increasingly focus on the shifting dynamics between German Bunds and Italian BTPs. Germany’s economic slowdown and rising political uncertainties are likely to push Bund yields higher. At the same time, Italy’s relatively stable political environment, robust investor base, and demand bolstered by the current macroeconomic landscape could set the stage for an unexpected alignment of yields over the long term.
The prospect of Italian BTP yields converging with German Bunds is remarkable—an idea that would have seemed unthinkable during the European sovereign debt crisis when Italy was labeled among the "PIGS." Now, such a convergence feels within reach, potentially simplifying the ECB’s task of ensuring uniform funding costs across the Eurozone.
However, it’s crucial to remember that markets often overreact to uncertainties. While the Bund-BTP 10-year yield spread may narrow, should Germany successfully restructure its economy, achieve recovery, and maintain a deficit below that of France and Italy, the spread could stabilize in positive territory—albeit at a low level. One viable approach to support this outcome would be for Germany to open up to the idea to issue debt at the European level to fund investments in critical sectors for the EU, such as defense.
Despite expectations of the European Central Bank (ECB) cutting interest rates, a return to zero rates seems unlikely—even if Germany’s economy struggles. Indeed, while lower interest rates can provide some relief, they won't address these structural challenges entirely. The need for energy reform, increased defense spending, and investments in technology require significant fiscal stimulus, which will translate to higher bond issuance.
Markets currently anticipate the ECB to lower rates to 1.75% by the end of 2025. Even with this, the German yield curve is likely to normalize, with 10-year Bunds potentially offering 100-150 basis points over 2-year Schatz yields. This scenario makes a 3% yield on Bunds more probable than the 2% levels we see today.
Italian BTPs stand out as well-positioned in this shifting landscape. Core inflation remains elevated at 2.7%, showing signs of stabilization above the ECB’s 2% target. This persistent inflation creates uncertainty about the ECB’s rate trajectory, especially as the central bank remains data-dependent.
Although markets predict a policy rate cut to 1.75% by late 2025, the ECB may proceed cautiously, influenced by macroeconomic indicators. In this environment, investors seeking inflation protection and higher yields—echoing trends from 2022 and 2023—will likely gravitate toward fixed-income securities. Italian BTPs, with their comparatively attractive yields, present a compelling opportunity.
Italian BTPs benefit from a uniquely stable ownership structure. Around 50% of BTPs are held by domestic investors, with another 24% held by the Bank of Italy, leaving foreign investors with just 26% of the market. Instruments like the BTP Valore, introduced during the COVID-19 pandemic, have further cemented this domestic base, incentivizing long-term holding through "fidelity bonuses."
In contrast, 46% of German government securities are owned by foreign investors, exposing them to greater volatility tied to market sentiment. This vulnerability is amplified by Germany’s current economic weaknesses, political uncertainties, and the prospect of upcoming fiscal stimulus.
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