COLUMN-The paradox of Italian inflation risk: Mike Dolan
(The author is editor-at-large for finance and markets at Reuters News. Any views expressed here are his own)
LONDON, May 19 (Reuters) – As inflation fears eat into bonds worldwide, Italy’s government debt has taken another beating – even though raging Italian inflation may seem like the most unlikely outcome imaginable.
Doubts have resurfaced this month over the scale of the European Central Bank’s pandemic support programmes ahead of its June 10 policy meeting.
Italy – with the bloc’s biggest bond market by size – benefits more than other euro countries from that bond buying. It stands to lose most from any rethink – even though an imminent “taper” of the ECB’s bond purchases seems far-fetched to most economists.
Europe’s economy continues to register positive data surprises and the euro zone is set to pick up pace as initially slow COVID vaccination programmes catch up fast, allowing movement restrictions across the continent to ease into summer.
And with headline inflation and inflation expectations rebounding sharply on both sides of the Atlantic – amid base effects and bottlenecks related to the pandemic shock – interest rate-sensitive securities everywhere have been pegged back.
It’s in that context that Italy’s long-term borrowing rates have risen again. Its 10-year benchmark government bond has lost 5% in price since the start of the year. The 30-year sovereign bond is down 15% and its 50-year issue is down 17%.
While these seem alarming at first glance – not even the tech-heavy Nasdaq 100 stock index lost that much – the drop tallies with similar price losses in similar maturities of U.S. Treasuries and other euro zone sovereigns.
Italy – a BBB-rated credit – can still borrow for little over 1% for 10 years and 2.4% for 50 years – roughly where it was last summer before investors welcomed the post-pandemic European Union Recovery Fund and bet on the steady hand of new Prime Minister and former ECB chief Mario Draghi.
Italy’s additional 10-year borrowing risk premium over Germany has widened back to about 120 basis points this week – but that’s still lower than pre-pandemic levels and less than half the peaks of the immediate COVID shock.
Inflation expectations embedded in euro zone and Italian bond and swaps markets have jumped back to about 1.6%-1.7% from as low as zero when the pandemic hit last year.
But they too still remain well below the ECB’s near 2% inflation target and about a percentage point below those in the United States.
SUB-ZERO REAL YIELDS
Most strategists reckon the ECB will be comfortable with these sorts of developments because it will view rising nominal bond yields as a welcome reflection of the underlying economic recovery and of inflation returning toward target.
The fact that inflation-adjusted, or real, 10-year Italian yields are still -0.60%, and -1.3% and -1.5% in France and Germany just reinforces the ECB’s perception that policy is still sufficiently easy and that there’s a way to go yet to entrench the recovery or sustainably meet its targets.
“While BTP spreads could widen further into the June ECB meeting, we do think that eventually they will provide an attractive opportunity to add back to peripheral risk,” said UBP strategist Mohammed Kazmi.
Far from a taper, Saxo strategist Althea Spinozzi thinks the ECB is more likely to up support next month than dial it back and Italy remains the best place in the government bond world to position for that. “From a buy-to-hold perspective Italian BTPs…are the only sovereigns offering a positive yield starting from four-year (bonds) onwards,” she says.
Longer term, the worldwide debate about reignited inflation seems at odds with arguably Italy’s most worrisome economic dynamic.
Only last week, Draghi addressed a conference on Italy’s plummeting birth rate – which fell even further during the pandemic, much like in the United States and China. At the same conference the Pope warned of a “demographic winter”.
Draghi said Italy had just 404,000 births last year, the lowest since records began and down 30% on 12 years ago.
The rapid aging of Italy’s population and the dearth of young workers is a huge pressure on future potential economic growth rates – and presents a challenge to the country’s ability to rein in record public debts of some 160% of GDP over time in the absence of ECB support and low borrowing rates.
Even before you consider that, European Commission forecasts show Italy’s output gap, which measures economic slack, remaining persisting at more than 1% of potential through 2022 even as Germany, France and Spain equivalents close next year.
Some argue the deepening “baby bust” and potential for looming worker shortages may well be inflationary over time as it forces up wages for the active younger people.
And other euro sceptics continue to think Rome’s public debt load could ultimately create intolerable euro strains that make the ECB’s job increasingly difficult – hence the small euro exit risk premium that persists for fear of future default and the potential for whirlwind inflation in event of a currency switch.
Whatever the long-term outcome, it will likely take considerable evidence to change from a decade of deflationary mindsets to the idea of Italian inflation becoming a serious risk.
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