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Politics and growth prospects loom large for Italy investors

Investors are in a "standoff" regarding 10-year Italian sovereign bonds, known as Buono del Tesoro Poliennale or BTPs, with much of the political outlook priced in by markets, according to Heinz Gunasekera, director of Barclays' European rates trading desk. Yet a potential downgrade to junk status by credit rating agencies, repeating the experiences of Portugal and Greece at the height of the European debt crisis, would be "a massive event,” he said.

An audience poll on Nov. 13 at the 13th annual AFME European Government Bond Conference in Brussels, Belgium, found that some 48% of respondents expect Italy to lose its credit rating as the country continues to battle the European Commission over the size of its planned fiscal deficit.

Ahead of the Italian government presenting a new 2019 budget proposal to the European Commission on Nov. 13, 10-year yields on Italian government bonds rose 3 basis points to 3.47%, while yields on 10-year German Bunds were unchanged at 0.40%

Speaking at the Association for Financial Markets in Europe's conference, Gunasekera said, "A lot of it is priced in terms of reactions from both sides," but noted the growth outlook will be key, with more investors returning to the front end of the Italian yield curve as there is greater clarity over the budget.

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However, he saw the possibility of an Italian downgrade as a potentially huge event as, around May and June, some €40 billion in BTPs moved from foreign hands to domestic investors and the European Central Bank, enough to swing the spread by 200 bps. "This would be an event that would be a multiple of that selling," he said, referring to a downgrade.

Other conference speakers noted that unlike countries such as Turkey, which has been hammered in the markets due to the reliance of its corporate sector on foreign debt, Italy is able to finance itself.

Giada Giani, a European economist at Citi, said foreign holding of BTPS (excluding the ECB) is the lowest it has been since 1998. But Gunasekera noted that while "Italy can finance itself, it's just a question of what level people are willing to finance Italy."

Losing rating grade status

Giani was less bearish on Italy's credit rating, despite the models used by the likes of S&P Ratings and Moody's Investors Service focusing on GDP growth and the stock of debt, which she conceded, at 132% of GDP, "obviously Italy doesn’t perform well on those metrics." But she pointed to some structural improvements, such as pension reforms and growth in exports, as reasons for optimism, despite the current populist government intending to reverse the former.

She was also less concerned about the potential for Italy to breach the European Commission's fiscal deficit ceiling of 3%, despite anemic economic growth. "Italy will never grow at 3% but it does not need to. It only needs 2% nominal growth, 1% real, 1% inflation. That will do."

Cristina Casalinho, chief executive of the Portuguese Treasury and Government Debt Agency, agreed, despite the "eye-popping" debt. "I find it difficult that Italy will be downgraded in the near future," she said, pointing out that when Portugal and Greece, two of Europe's periphery economies that suffered downgrades to junk status during the European debt crisis, had similar external problems to Turkey, rather than a specific debt problem.

"Italy is able to produce 2% GDP primary surplus even with very low growth, and this is not something that every country can," Casalinho said.