Global bond markets are pointing to risk-off, particularly regarding Italy

As the Dow Jones Industrial Average flirts with a 500 point decline, it’s worth mentioning the flight to safety going on in the global bond markets. We are seeing major moves into sovereign bonds across currency areas. That has the US 10-year down 7.4 basis points today. And it also has the 10-year German Bund down 4.3 basis points. Australia, France, Spain and the UK are seeing similar moves.

The two countries bucking the trend that stand out are Japan and Italy.

The Italian situation

Japan’s market is unique given the central bank’s control over long-dated interest rates. So I wouldn’t make too much out of the Japanese situation. The Italian move to 3.557% is an altogether different scenario. That’s up 8 basis points when even the Greek 10-year bond is down marginally on the day to 4.31%. And that’s because Italy is now the major risk in the EU. So flights to safety are now flights out of Italian sovereign debt and into other securities.

Just today, it was reported that the European Commission will formally reject Italy’s budget proposal. Here’s how Reuters is reporting it:

The European Commission has rejected Italy’s 2019 budget and will ask Rome to present a new document within three weeks, Italian news agency AGI reported on Tuesday, citing EU sources.

The Commission will hold a news conference at 3:30 p.m. (13:30 GMT) to formally announce the decision, AGI said.

Italy’s government of the right-wing League and anti-establishment 5-Star Movement has been locked in a dispute with Brussels over fiscal issues and presented a budget plan this month that hikes the deficit to 2.4 percent of gross domestic product.

That was sharply up from a targeted 1.8 percent this year, flouting EU requirements that the deficit should fall steadily towards a balanced budget.

Now, remember that 2.4% is still very much in line with the Maastricht deficit hurdle. Italy’s problem is that, particularly with interest rates rising, the 2.4% number increases the country’s debt to GDP ratio. And that’s against the Maastricht stability and growth pact if a country’s debt burden is over 60% of GDP.

So we have a standoff here. And it’s unclear where this is headed. That’s why Italian bonds are selling off.

What Moody’s says

On Friday, the ratings agency Moody’s downgraded Italy but put a stable outlook on the new lower credit rating. That means that, while Italy is now just a notch above junk, it will take something fairly dramatic to change the outlook. Moreover, the official review started 5 months ago and concluded today. So I reckon Italy has another six months of rope here

Here’s how Moody’s worded their press release:

Moody’s Investors Service has today downgraded the Government of Italy’s local and foreign-currency issuer ratings to Baa3 from Baa2. The outlook on the rating has been changed to stable. This concludes the review initiated on 25 May…

The key drivers for today’s downgrade of Italy’s ratings to Baa3 are as follows:

1. A material weakening in Italy’s fiscal strength, with the government targeting higher budget deficits for the coming years than Moody’s previously assumed. Italy’s public debt ratio will likely stabilize close to the current 130% of GDP in the coming years, rather than start trending down as previously expected by Moody’s. Moreover, the public debt trend is vulnerable to weaker economic growth prospects, which would see the public debt ratio rise further from its already elevated level.

2. The negative implications for medium-term growth of the stalling of plans for structural economic and fiscal reforms. In Moody’s view, the government’s fiscal and economic policy plans do not comprise a coherent agenda of reforms that will address Italy’s sub-par growth performance on a sustained basis. Following a temporary lift to growth due to the expansionary fiscal policy, the rating agency expects growth to fall back to its trend rate of around 1%. Even in the near term, Moody’s believes that the fiscal stimulus will provide a more limited boost to growth than the government assumes.

The stable outlook reflects the broadly balanced risk at the Baa3 rating level. In Moody’s view, Italy still exhibits important credit strengths that balance the weakening fiscal prospects. These strengths include a very large and diversified economy, a solid external position with substantial current account surpluses and a near balanced international investment position. Italian households have high wealth levels, an important buffer against future shocks and also a potentially substantial source of funding for the government.

Nothing in this statement says that Moody’s intend to lower Italy’s credit rating any further. However, if Italian bonds do continue to sell off, perhaps the resulting negative impact on debt to GDP ratios will force Moody’s to revisit its stable rating. That doesn’t mean a downgrade would be imminent. Barring a drastic change in circumstances, we would need to see an outlook downgrade and then a review. This is why I think Italy has time.

Back to the global situation

On the bond market more generally, we are seeing jitters that are related to the pace of growth in the global economy. And we often see this kind of market volatility in October. So I am not alarmed at the change in sentiment.

Nevertheless, the bond market rally in the face of a global selloff in shares is a cross across the bow of those who are bullish on prospects for the global economy. We are now back to a world of policy divergence and dollar strength. And that’s negative for global growth, particularly in the emerging markets.

I am still a long way from thinking this expansion is in its death throes. I need to see data showing a discernible slowing. And that data isn’t there. For me, 2019 is when things will change more dramatically. Markets are pointing to risk off for now. But I believe the volatility today will likely pass.

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