Why Italy's bond spread over Germany has dropped below 100 basis points

By Stefano Rebaudo

(Reuters) - The closely-watched premium investors demand to hold Italy's 10-year bonds over Germany's fell below 100 basis points on Wednesday to its lowest since 2021 after German political parties backed a loosening of the country's debt brake.

Parties hoping to form Germany's next government agreed to create a 500 billion euro ($534.5 billion) infrastructure fund and overhaul borrowing rules in a tectonic spending shift to revamp the military and growth in Europe's largest economy.

Plans for joint European Union borrowing to fund defence will be crucial to support Italy’s government bonds.

Lowering the spread has been a key goal for Italy's politicians since the euro zone debt crisis and frequently made the TV news bulletins. It was at around 250 bps in October 2022 when Giorgia Meloni became Italy's prime minister.

HOW SIGNIFICANT IS THIS MOVE?

The Italian/German bond yield gap, also known as the spread in financial markets, has only traded below 100 bps on a handful of occasions over the last 15 years.

In recent history, this includes two key periods.

Under former prime minister Mario Draghi in 2021, structural reforms were implemented to secure and efficiently utilize the EU post-COVID recovery funds, narrowing the spread.

Efforts to contain spread widening by the EU and European Central Bank at the height of the pandemic were also crucial to containing euro zone borrowing costs.

And earlier, in 2015 the ECB unleashed massive monetary stimulus to boost inflation, dragging government borrowing costs down.

This all helped ease pressure on Italy by supporting the economy, increasing tax revenues, and lowering interest payments.

The recent narrowing contrasts sharply with the past. The spread surged to over 500 bps during the 2011 euro debt crisis, to around 300 bps in 2018 when populist parties in power raised concerns about Italy's exit from the euro and then, briefly above 300 bps again as the COVID crisis broke out.

WHY IS ITALIAN DEBT VIEWED AS LESS RISKY NOW?

A number of reasons.

Generally speaking, greater signs of European cohesion are seen as positive for Italy and containing its borrowing costs. So no surprise that the latest spread tightening follows efforts to step up European cohesion.

Italy's debt-to-GDP ratio meanwhile has returned to pre-pandemic levels of around 135%. While still elevated, debt has come down from over 150% in 2020, with further declines expected from 2027.

ECB rate cuts and other euro zone policy steps have helped.

The ECB's Transmission Protection Instrument set up in late 2022 is designed to protect bond markets at times of stress by buying bonds, while the EU eased rules in late 2023 to make it less challenging for member states to reach fiscal targets.

Finally, political stability in a country renowned for short-lived governments contrasts with political instability in France and Germany.

WHAT'S NEXT?

Most analysts expect bond yield premiums across the euro area to continue narrowing.

Markets expect the ECB to cut rates by a further 70 bps this year, helping keep downward pressure on bond yields which would benefit heavily indebted states like Italy.

WHAT ABOUT ITALIAN RETAIL INVESTORS?

Well, they play an increasingly important role in buffering Italy from volatility in global bond markets.

Italian retail investors increased bond holdings between the second quarter of 2022 and the third quarter of 2023, more than offsetting reduced demand from financial institutions and the ECB, a trend not seen in France or Germany.

Citi reckons a key risk to the valuation of Italian bonds going forward is declining retail demand.

The share of Italy's debt owned by retail investors was around 15% in October 2024 the highest since 2014. It hit 19% in January 2012 with BTP yields at over 6%.

Hedge fund activity across European bond markets, including in Italy's, has also shot up in recent years.

WILL THE GOOD NEWS LAST?

There are some reasons for concern, for sure.

Italy remains one of Europe's most indebted economies and worries about growth economic prospects remain.

Italy's budget watchdog recently cut its GDP estimates to 0.7% in 2024 and 0.8% this year, down from October projections.

All else being equal, stronger economic growth can help stabilise or reduce a country's debt burden.

(Reporting by Stefano Rebaudo; Graphic by Harry Robertson; Editing by Dhara Ranasinghe and Christina Fincher)