Women walk in Rome near the Vatican
Italian bond markets have been helped by a period of relative political calm in Rome since the election last October of Giorgia Meloni, the rightwing prime minister © Antonio Masiello/Getty Images

Italy’s sovereign debt has handed investors the best returns among big global government bond markets so far this year, confounding expectations that a rapid rise in eurozone interest rates would reawaken investor fears over the highly indebted country’s finances.

Italian bonds, which trade at yields far above those of Germany — the eurozone’s de facto haven benchmark — have long been viewed as a barometer of political and financial risks in the currency bloc. But their relative stability this year, even as the European Central Bank ends large-scale bond purchases and ratchets up borrowing costs, has surprised some investors who worried the central bank’s monetary tightening could widen the cracks in the region’s debt market.

“Italy has held up a lot better than we thought it was going to,” said Iain Stealey, international chief investment officer for fixed income at JPMorgan Asset Management. Stealey had expected an underperformance in Italian debt as the ECB cut its bond buying and raised its deposit rate from minus 0.5 per cent in July to 3 per cent at its most recent meeting last month. 

An ICE Bank of America index of Italian government debt has gained 3.5 per cent so far in 2023, eclipsing peers in the euro area and other big sovereign bond markets around the world. French bonds have gained 2.6 per cent, while US and German bonds are both up by 2.2 per cent.

Bar chart of Year-to-date government bond returns (%) showing Italy leads the way among big bond markets

As a result, the gap or “spread” between Italy and Germany’s 10-year debt — a key gauge of risk — has remained much narrower than the majority of last year. It has traded in the range of 1.7 to 2 percentage points this year, down from a peak of over 2.5 percentage points last autumn.  

The ECB has been slowly reducing its bond purchases as it withdraws monetary stimulus in response to high inflation. In March, it started to shrink its almost €5tn bond portfolio by not replacing €15bn of securities that mature each month.

Some of the more hawkish members of the ECB governing council have called for it to accelerate the pace of shrinking its bond portfolio to €25bn a month when this so-called quantitative tightening is reviewed in July. 

However, the ECB has said its €1.7tn Pandemic Emergency Purchase Programme will continue reinvestments until at least the end of next year. It has the flexibility to direct Pepp reinvestments more towards the bonds of countries with disproportionately higher borrowing costs — such as Italy — as it did during a bond market sell-off last summer.

The central bank has also created a new tool called the transmission protection instrument (TPI). This is so far untested, but would allow the ECB to buy unlimited amounts of bonds of any country judged to be suffering from an unjustified rise in its borrowing costs. It is widely seen as an extra protection against the risk of rising interest rates triggering a debt crisis in Italy.

Line chart of Spread on Italian 10-year government debt over Germany showing Italy's risk premium has been steady this year

Lorenzo Codogno, a former director-general at the Italian treasury, said ECB bond purchases have been “essential” to prevent Italy’s borrowing costs from surging higher. 

Antoine Bouvet, head of European rates strategy at ING, said he was surprised that the mere threat of bond purchases under the TPI had been sufficient to steady the market. “I thought there was a risk the market would challenge the ECB’s credibility but it hasn’t,” he said.

Italian bond markets have also been helped by a period of relative political calm. Giorgia Meloni, the rightwing prime minister who was elected in October, has avoided confrontation with Brussels, unlike the populist coalition that unnerved markets in 2018.

“The current right-leaning government has behaved responsibly, at least on economic matters,” Codogno said. A sharp drop in natural gas prices has given an extra boost to the Italian economy, which is expected to grow 1.2 per cent this year, outpacing the ECB’s 1 per cent growth forecast for the wider eurozone, he said.

Markets are currently pricing in a peak in the ECB’s deposit rate at around 3.75 per cent later this year — matching its previous peak in 2001. But if eurozone inflation proves tricky to curb, and the central bank needs to lift borrowing costs even further — in turn pushing up government borrowing costs across the bloc — then some investors are concerned about the implications for the stability of Rome’s large debt pile of more than 140 per cent of gross domestic product.

“If inflation doesn’t come down, then central banks need to deliver more than what’s priced in currently and there are financial stability challenges ahead,” said James Athey, a bond portfolio manager at Abrdn. 

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