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There We Go Again

18 October 2018 by jbchevrel

Today Italy 5y CDS widened to the highest since H1-2013, after the European Commission said that the Italian populists’ spending plans are excessive and asked for an explanation. The EC likely dislikes not only the deviation, but also the fact that the deviation is planned to persist through time, as opposed to a one-off. That took us to 327 on the 10y BTP-Bund spread. What now? The Italian government has received a letter from the EU, requesting changes to its draft budget plan by OCT 22. Then, S&P and Moody’s are due to review their respective ratings before the end of this month. As I write Italy is still BBB(=) / BBB(-) / Baa2 (-). A big question is whether the next rating reviews will lead the BTPs out of the mainstream € bond IG indices. In terms of index inclusion, you need 4 cumulative notches of downgrades to get out of the Bloomberg-Barclays index. With 2 notches by both S&P and Moody’s, BTPs also exit the Citi index. The barrier is higher (5 notches) to see BTPs kicked out of the Markit iBoxx and ICE indices. A decent part of this downgrade/index risk is already priced in, which does not mean we cannot go wider. My view on Italy has not changed since my AUG 3 post, as I do not see catalysts to go significantly tighter from here. I think that the Italian government is unlikely to backtrack easily unless the markets put more pressure on them. Remember they have the EU elections next year. Looking at recent polls, PD + Forza Italia represent less than a quarter of Italian voters, which also tells me that the probability of a snap election before year-end (i.e. when a budget must be passed) is low. Adding to that, risk premia globally seem on the way higher, the ECB’s PSPP net purchases are set to stop at the end of this year.