Italian Bonds Resume Slide After Report Europe Will Reject Budget Proposal

Italian bonds resumed their slide, dropping for a third day as investors were spooked by the looming conflict between the populist government and European Union over the country’s budget proposal. Today's selloff catalyst was a report by Italy’s La Repubblica newspaper which reported that there had been “rumors” that the EU would reject the country’s proposals. European Commission Vice President Valdis Dombrovskis said Friday that Italy’s plans did not seem in line with the bloc’s stability and growth pact, even though the EU had made such concessions in previous years to Spain and Portugal.

As a result, Italy’s two-year yields rose as much as 14 basis points to 1.17%, while yields on 10-year notes rose 7 bps to 3.22% with the yield spread over their German peers at 274 basis points, just short of Friday’s highs. However, after an initial selling burst, yields have since pared much of the losses.

"Headlines suggesting the EU will look to reject the budget all but places the populist coalition and the EU on a potential collision course,” said Rabobank's Matthew Cairns "That is feeding straight into BTP levels this morning."

While the early rumors were largely discounted, investors braced themselves for any comments from EU leaders on the sidelines of a Eurogroup meeting in Luxembourg. Meanwhile, as Bloomberg reports Italy’s Five Star Movement-League coalition has yet to lay out growth targets that formed the basis for the 2019 deficit target of 2.4%, which spooked investors Friday and prompted a hostile response by the EU.

Italy's full budget proposal which was announced on Thursday will need to be handed over to the European Commission for full review on Oct. 15. Any rejection by the EU could cause rifts between Italy’s euroskeptics and the trade bloc, creating further market volatility.

Taking the other side of the argument, Italy's Finance Minister Giovanni Tria told Il Sole 24 Ore that the higher-than-expected 2019 budget target is not a challenge to EU limits, adding that he had never threatened to quit, another potential selloff catalyst.

Also on Monday, Italy's Prime Minister Giuseppe Conte said in a Facebook post that his government has set the foundations for "a serious and courageous budget," even as growth details were lacking. Conte wrote that the budget "looks to growth" within a framework of stable public accounts; he also said that looking back over government’s first four months in power, the budget wants to offer an answer to rampant poverty, pensioners, families, savers hurt by bank crises."

Meanwhile, even as bonds sold off, there was a modest relief rally in Italian stocks, with the FTSE MIB benchmark index rising 1.7%, partly reversing Friday’s 3.7% drop, and leading gains in major European markets on Monday.

The FTSE Italia All-Share Banks Index is up 0.8%, underperforming the MIB. On Monday, Citi cut Italian banks to neutral from overweight citing the political uncertainty.

Popular Italy hedges continued in the market Monday, with traders placing call trades on two-year German bonds, called Schatz. Such a trade involves positioning for a large gain, which could come from a flight to safety.

Fueling bearish sentiment, Natixis strategists targeted a Italy-Germany 10-year yield spread of 300 basis points, focusing on potential ratings downgrades from Moody’s Investors Service and S&P Global Ratings.

“A wave of negative rating actions would have far greater implications than a simple sell-off of Italian assets, one would assume that the Italian government would end buckling under the pressure,” wrote strategists led by Cyril Regnat. “If both Moody’s and S&P decide to downgrade Italy and maintain a negative outlook on the debt, this would pave the way for significantly wider spreads, possibly around 400 basis points."