Italy Folds To Europe, Pledges To Shrink Budget Deficit To 2.0%; Euro Surges

After two days of brutal punishment by the markets which sent Italian bond yields to 4 years highs and slammed the euro, the Italian government appears to have folded to pressure from Brussels (and the one place in the world where the bond vigilantes still operate, just ask Sylvio Berlusconi), and according to Corriere della Sera, Italy’s draft budget plan will pledge to cut the deficit to 2% in 2021, after Rome reversed a proposal to maintain a 2.4% shortfall in the face of pressure from the EU. As a result, while the 2019 deficit will still rise to 2.4% of GDP in 2019, it will decline by 0.2% to 2.2% in 2020, and another 0.2% the year after.

In kneejerk reaction, futures lept to fresh session highs, Treasury yields jumped by 2bps to 3.07% and the EURUSD spiked 50 pips higher to 1.1590.

Italy is not out of the woods yet though: according to Mizuho, the sustainability of the euro’s rebound will depend on whether the EU sees Italy’s latest budget plan as appropriate. It could be that Italy has already made compromise with the EU, but hard to predict whether the euro’s rebound has more legs until we see a reaction from the EU: "It all boils down to the EU’s response", and if the ongoing war of words is any indication, merely promising to trim the deficit in the next three years will hardly be smiled upon.

Others were even more skeptical. According to bond fund manager Daintree Capital, "The euro’s definitely reacting to the headlines on Italian budget plans, and it will continue to do so for future headlines." However, "anyone who believes a populist government is all of a sudden going to be particularly responsible in a fiscal sense, has a misguided view."

As a result, Daintree's Justin Tyler said that "I do see the euro as potentially being a bit of a weak point in G-10. There’s lots of political risks coming out of Italy.”

Finally, there is Bloomberg's Mark Cudmore who writes that the "euro reaction is excessive and won't sustain" because the proposed budget deficit target is still too late "and it's two years too late anyways. There's justification for some positivity in that the Italian government are trying to address market concerns. But that's largely eroded by the fact that this is little more than a token gesture and insufficient to ease Italy's debt burden. And that suggests that the government still don't register the severity of the situation."

Finally, even if the deficit were to shrink modestly, that only impacts one of the three triggers listed by Goldman earlier today why volatility in Italian bonds won't sustain. The other two - the phasing out of the ECB's QE and the collapse in Italian bond volatility - are here to stay, and merely await the next catalyst out of Italy's populist government to send yields soaring even higher.

Finally, don't be surprised if a member of government comes out in the next few hours and denies the whole thing.