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Investors price in a downgrade of Italy by rating agencies

Italian borrowing costs have remained elevated as investors priced in their expectations of downgrades of Italian debt by the credit rating agencies, as Italy's government collides with the European Commission.

Since unveiling its draft budget that would increase Italy's annual fiscal deficit to 2.4% of GDP — flying in the face of agreements with the EC to tackle the country's debt mountain — Italian politicians have staunchly defended their policies ahead of the submission of the budget to the commission on Oct. 15.

The government has given some ground, revising its original deficit targets down, from 2.4% for each of the next three years to 2.1% in 2020 and 1.8% in 2021. However, investors have little confidence that these targets will be met.

The deficit figure is premised on GDP growth of 1.5%, an estimate deemed heroic by both the market and the International Monetary Fund, which revised down its forecast for Italian GDP growth to 1.2% in 2018 and just 1.0% in 2019.

AXA Investment Managers expects the EC to find the budget in breach of the Stability and Growth Pact, the EU-wide agreement to coordinate economic policies and request the Italian government to submit a new draft budget.

The optimistic GDP level risks "significant fiscal slippage risk ahead," agreed Axel Botte, a strategist at Ostrum Asset Management who said that rating downgrades are "inevitable."

AXA Investment Managers anticipates Moody's and Fitch Ratings to downgrade Italy by one notch and S&P Global Ratings to downgrade its outlook on Italy to negative.

Scope Ratings has suggested it could also downgrade Italy. The agency said the draft budget deficit goal could compound the existing concern surrounding the sustainability of the country's debt burden. "This represents a significant risk to Italy's A-/Negative Outlook ratings," the group noted.

ING expects a one-notch downgrade from Moody's to maintain the 10-year spread between Italian government bonds, or BTP, and German Bund spread in "the upper half of the 200-300 bps range" over the coming months. "If S&P also downgrades Italy's credit rating — and not just the outlook as our base case assumes — a sustained break above 300 bp might unfold," the bank wrote. The spread stood at 297 basis points as of 11:36 a.m. ET on Oct. 9.

Speaking at a press conference alongside French far-right leader Marine Le Pen on Oct. 8, Italy's deputy prime minister, Matteo Salvini, labeled EC President Jean-Claude Juncker, and the European Union bureaucracy in Brussels, "enemies of Europe," sparking a further rout of Italian bonds.

"Italy's radical leaders have turned into their own worst enemies," wrote Holger Schmieding, chief economist of Berenberg Bank. "Instead of trying to reassure nervous investors, the top leaders of Five-Star and the League [coalition government partners] have inflamed passions by telling markets that they would not care even if the BTP-Bund spread were to surge to 400 bps," he said.

Following a spike in earlier trading, the yield on 10-year BTPs settled Oct. 9 and was down 5 basis points in the day at 3.51% as of 11:36 a.m ET.

This S&P Global Market Intelligence news article may contain information about credit ratings issued by S&P Global Ratings, a separately managed division of S&P Global. Descriptions in this news article were not prepared by S&P Global Ratings.