Italian sovereigns: escape from Westphalia or ECB noise?

Originally Posted, 28 May 2024 – Italian sovereigns: escape from Westphalia or ECB noise?

The recent global risk rally has been shaped by lower inflation, prospects for policy easing and expectations of a soft landing for growth. While the rally has been led by equities, high yield credit and emerging market debt, it has also extended to longer dated peripheral eurozone sovereign bonds. 

• Italian government debt has often traded as a gauge of risk appetite within the Eurozone, and proved popular with investors, looking to benefit from the extra yield pick-up over Bunds.
• But is there more than meets the eye? Despite not having full monetary sovereignty, Italian BTPs, like all other Eurozone government debt, are also supported by other ECB asset purchase mechanisms in the event of severe market turbulence, thus significantly reducing their risk of default.
• While BTP spreads have some value as a gauge of investor appetite, the relationship is not linear and may be asymmetric. Wider BTP spreads are likely to remain a reliable guide to diminished investor risk appetite, but stable spreads may not reveal increased risk appetite if they are attributable to ECB emergency interventions.

In April 2024, resilient US economic readings and an uptick in inflation quelled hopes of early rate cuts, causing a reversal in both bond and equity markets. But Italian government bond (BTP) returns remain near the top of the performance table, even if we include the April back-up in bond yields. BTPs have gained about 1-3% and 6-8%, in local currency terms, in the year to date and over 12 months, respectively. 

The longest BTP maturities, which have greater duration (i.e., price sensitivity to yield moves), have performed particularly well. BTPs with a 20-year plus maturity have recovered more quickly since the 2022/23 bond market downturn than, for example, long dated US, UK, German and Canadian sovereign bonds, which have lost between 7-15% in price over the last 12 months.

Table 1: Long Italian government debt among the top performers.

Source: FTSE Russell, an LSEG Company, as of April 30, 2024, total return, in local currency terms. Past performance is no guarantee to future results.

Smoke and mirrors?

In the strictly Westphalian^[1] sense, as a member of the eurozone, Italy does not have monetary sovereignty (the ability to create its own money). As a result, BTPs tend to trade at a yield premium to compensate for Italy’s higher debt levels and higher credit risk when compared to the AAA-rated government debt issued by eurozone governments like Germany and the Netherlands. 

But Italian government debt has often traded as a general gauge of risk appetite within the eurozone and proved popular with investors looking to benefit from the extra yield pick-up over German government bonds (Bunds). Notably, the cumulative performance in Chart 1 shows a strong outperformance from both BBB-rated eurozone sovereigns, Italy and Greece, since 2019 in euros. Indeed, they are the only Eurozone sovereigns to show positive returns, even if modest.

Chart 1: Investors turned to lower-grade eurozone sovereigns for extra yield

Source: FTSE Russell, an LSEG Company, total returns from March 31, 2019 to April 30, 2024 in euros. Past performance is no guarantee of future results.

Italian spreads narrowed sharply after ECB support mechanisms calmed markets

Despite not having full monetary sovereignty, Italian BTPs, like all other eurozone government debt, are supported by the European Central Bank (ECB). The ECB has put in place a series of asset purchase mechanisms to protect eurozone bond markets in the event of severe turbulence, thus significantly reducing their risk of default.

Firstly, the PEPP (pandemic emergency purchase programme) programme^[2], which has been in place since Covid, made net purchases of bonds until 2022, when it was scaled back to re-investing only the proceeds of maturing debt until the end of 2024. The PEPP is likely to have played a significant part in preventing government bond yields from rising further since 2022. 

Secondly, the ECB has allowed PEPP reinvestments to be skewed towards those eurozone countries facing a disproportionate rise in borrowing costs, like Italy and Greece, helping lower those countries’ yield spreads. Since Italy has one of the highest public debt/GDP ratios within the region (see Chart 4), this measure is important to ensure that default risk remains low.

Thirdly, the ECB introduced the Transmission Protection Instrument (TPI) in July 2022. The TPI is a bond purchase scheme targeting individual countries, aimed at safeguarding monetary policy transmission across the eurozone and avoiding financial fragmentation. It is designed to allow potentially unlimited intervention to prevent self-fulfilling crises. The introduction of the TPI followed in the footsteps of the “whatever it takes” statement from former ECB President Mario Draghi in July 2012. This statement by Draghi carried a thinly veiled threat to markets of extreme and unlimited intervention to protect the debt, and effectively the monetary sovereignty, of eurozone member countries.

The “whatever it takes” statement was followed in 2012 by the introduction of an outright monetary transactions programme or OMT. This was the first anti-crisis instrument with which the ECB can make outright transactions in the secondary sovereign bond markets. OMT operates under certain conditions and proved a turning point in the eurozone sovereign debt crisis.

The OMT and—since the Covid pandemic—the PEPP represent ‘the first line of defence’ for eurozone bond markets. Meanwhile, the TPI is the ‘secondary line of defence’. It “deals with the on-going process of interest rate normalisation as part of a last-resort intervention, coming close to what is expected from single-country central bank”^[3]. 

Like OMT, the TPI has never been truly tested. However, so far, the announcement effect has been sufficiently powerful to help correct the widening of government bond yield spreads in more fragile eurozone countries like Italy. In 2022, after PEPP net bond purchases had stopped and the ECB had tightened policy, the TPI served to restore market confidence, as can be seen in Chart 2.

Both Italian and Greek spread levels had risen to levels that indicated concerns about default risk. However, once the ECB brought in TPI, both Italian and Greek government bond spreads contracted sharply and they have continued to do so since.

Chart 2: Escape from Westphalia? BTP spreads fell following 2022 ECB interventions

Source: FTSE Russell, an LSEG Company, Data from April 30, 2021 to May 9, 2024. Past performance is no guarantee of future results.

It is also worth noting that spreads fell largely amid an outright decline in Greek and Italian sovereign yields, helping to reduce default risks (see Chart 3). This was a more favourable outcome for the structural stability of the eurozone than a situation where yields in Greece and Italy were rising less than core country yields.

Chart 3 Selected Eurozone sovereign yields

Source: FTSE Russell, an LSEG Company, Data from April 30, 2021 to May 9, 2024. Past performance is no guarantee of future results.

Disinflation also drove BTP spreads lower

In addition to these ECB support mechanisms, BTP spreads are likely to have benefited from rapidly falling inflation. As Chart 4 shows, Italian consumer price inflation fell from a peak of 12.6% year-on-year in November 2022 to just 0.9% year-on-year at the end of April 2024. This is well below the ECB’s 2% inflation target, also below the latest eurozone inflation average of 2.4%. Italian inflation has remained at sub-2% levels for several months, suggesting this may be a more fundamental shift than solely the result of year-on-year base effects in the inflation calculation.

Chart 4: Lower inflation has helped tighter BTP spreads

Source: LSEG Workspace, data from 15 May 2019 to 15 April 2024. Past performance is no guarantee of future results.

Italy’s debt to GDP ratio fell sharply, even if some of this is a measurement effect

Moreover, despite remaining one of the highest debt/GDP ratios within the Eurozone, and an area of concern for the ECB, Italy’s public finances have improved since Covid, with its public debt falling to 137% of GDP in December 2023, having reached 155% during Covid in 2020 (see Chart 5), but it remains much higher than the eurozone average of 82%. Although some of the recent decline reflects the impact of higher inflation in boosting nominal GDP, Italy has also achieved a bigger decline in debt per GDP than other eurozone countries.

Chart 5: Italy’s public debt/GDP ratio fell further than the EU average since Covid

Source: LSEG Workspace. Data from 14 May, 2004 to 29 December, 2023. Past performance is no guarantee of future results.

Are BTP spreads a reliable gauge of investor risk appetite?

Chart 6 shows the recent relationship between the performance of Italian equities and that of 7–10-year BTPs. In 2022, both Italian bond and equity returns suffered from higher inflation, the prospect of higher interest rates and the end of net asset purchases by the ECB. 

However, both markets’ performance recovered after the ECB skewed its reinvestment asset purchases to more fragile economies. As described earlier, the introduction of TPI made BTPs attractive again to investors for their yield pick-up relative to German Bunds. By Q4 2023, bond markets had partly joined the equity rally after pricing in earlier future interest rate cuts, propelling Italian bonds to the top of the performance table.

Chart 6: Italian equities and govt bond returns

Source: FTSE Russell, an LSEG Company, Data from 9 May, 2019 to 9 May, 2024. Past performance is no guarantee of future results.

Italian bond-equity return correlations rose after Covid…

Chart 6 also shows that the correlation of returns between Italian equities and government bonds increased sharply during the inflation shock in 2021-22, as both asset classes sold off sharply. This rise in bond-equity correlations was mirrored in other global markets.

However, the subsequent gains in Italian equities have far exceeded those in government bonds and the bond-equity correlation has fallen back. This may be evidence of a non-linear relationship between BTP spreads and equity market returns, whereby Italian equities can perform strongly, provided BTP spreads do not exceed certain threshold levels.

…but ECB interventions make BTP spreads a noisy guide to risk appetite?

This would suggest that BTP spreads have some value as a gauge of investor appetite. However, the relationship is not linear and it may be asymmetric. Wider BTP spreads are likely to remain a reliable guide of diminished investor risk appetite, ceteris paribus. On the other hand, stable spreads may not reveal increased risk appetite if they are attributable to ECB emergency interventions.