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By Antonio Serpico
Following a strong rally in Italian government bonds, we may see headwinds in 2023.
Italian government bonds, or BTPs, started the year on a strong note, tightening 30 basis points versus the Bund. Today they trade at around a 180bps spread—a tight level last seen in April 2022*. In our view, the rally was prompted by a blend of yield-hunting and investor confidence in the new national government, which was elected in October.
Indeed, the new right-wing leadership quickly put aside its populist intentions, including a proposal for a flat tax and an increase in the minimum pension, which were widely discussed during the election campaign. The new government also took a more pro-Europe stance than expected, while avoiding any proposals that would substantially increase Italy’s fiscal deficit. More importantly, it maintained continuity with policies employed by the previous government under Mario Draghi, for example completing the necessary steps to receive grants and loans under the next-generation EU funding programme.
In addition, the recent collapse of gas prices helped BTP spreads, given Italy’s reliance on gas imports. Last but not least, recent upside surprises in Italian macro data, including service PMIs and retail sales, together with improved prospects for the European economy in 2023, help Italian debt to outperform.
That said, we think Italian spreads could face some headwinds from here.
Italian debt issuance is likely to grow materially, even as the European Central Bank starts quantitative tightening in March. The result could be record-high net supply of €90 – 110 billion for 2023. This compares to around €10 billion net new issuance in 2022. Moreover, the funding plan from the Italian minister of finance includes reduced supply in the front end of the curve and increased supply at the longer end—potentially weighing on 10-year bond prices.
From a valuation perspective, we think that the 10-year BTP is starting to look expensive. It currently trades at around 60bps north of the Eurozone market-implied terminal rate of around 3.3% compared to a 100bps spread over the terminal rate prior to the ECB’s December meeting—when the ECB’s quantitative tightening is expected to start later than its currently planned 1Q23 launch*.
Yes, the ECB has introduced the so-called Transmission Protection Instrument, which should insulate BTPs from spread-widening to some degree. However, we think this is more a reactive tool that will ultimately only partially reduce the headwinds faced by Italian debt in the new year.
*Data sourced from Bloomberg
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