The last couple of weeks have been fairly agitated in the bond markets. There was an overall repricing by market participants in these instruments all across the Western world, following an acknowledgment of the “higher-for-longer” narrative – considering that yields have to be at relatively high levels for a long period of time. But why is it picking up steam? One simple reason. And even though I try, I think I’ll never write a ‘Week at the Close’ article without mentioning it, so I can go (against my will) straight to it: INFLATION.
The movement in oil prices in the last days of September was the primary trigger for this market fright. On the 28th, oil prices hit a 10-month high. Also on the 28th, the day of my anniversary, I was at some point in the night discussing with a friend about the (then) fresh news on Italy’s government projections for its 2024 budget deficit. What a great conversation to have on a birthday, isn’t it? We couldn’t be deeper in the hole…
This was quite relevant to the bond market. It added a bit of gasoline to the small flame that was surging. After years of complacency on the EU’s deficit rules sparked by the impactful events of 2020 and 2021 (the pandemic) and 2022 (war in Ukraine), the suspension of the 3%-of-GDP deficit rule is ending on the 1st of January of 2024. However, two of the biggest European economies, Italy and France, will keep exceeding the ceiling. In both governments’ view, the hurry implicit in the European institutions’ rules is very prone to be counterproductive by jeopardizing economic recovery.
While Italy is projected to return to this 3% limit by 2026 and France only by 2027, the situation is more alarming in the former. That’s obviously because of the huge outstanding debt-to-GDP ratio of the country. With the upward revision of the deficit from 3.7% to 4.3% of output, the debt is projected at 140.1% of GDP for next year. Economic growth for the next three years, starting in 2024, is expected by the government at, respectively, 1.2%, 1.4% and 1%.
Given the sluggish growth prospects, the Finance Minister of Giorgia Meloni’s government was clear as water, stating that they “don’t respect the 3%” limit. Giancarlo Giorgetti’s earlier projections of above-1% growth for the country this year are being hurt by the overall industrial slowdown. He has recently taken a shot at the ECB for the path of reference rate increases, stating that this will bring to the country’s already vulnerable finances an extra weight of about €15 billion in interest costs.
Not only that but also the “Superbonus” tax scheme – consisting of a 110% tax credit for housing renovations related to energy efficiency – is putting a significant (around €140 billion) burden on the budget, even with the government, particularly the prime minister Meloni, being vocal in criticizing the scheme.
The impact of this postponement was felt in the market through the usual channel of treasury bonds. The yield on the 10-year Italian treasury bond rose, at a certain point last week, 17 basis points, almost breaking the 5% mark – standing at 4.96%, the highest in a decade. In fact, the benchmark to which European yields are compared was already up. The 10-year German government bonds plummeted as their yield breached 2.8%, the highest since the midst of the Global Financial Crisis. The month of September saw the 10-year bund yield jump 30 basis points upwards. More remarkably, though, spreads widened in a considerable fashion. For the first time since March, the difference between Italian and German bond yields reached 2 percentage points, after a 6-basis-point widening of the spread on the 28th.
The surge in borrowing costs of the country’s debt was manifested in a recent treasury auction. Last week, a € 3 billion sale of 10-year Italian government bonds was offering auction participants a generous 4.93% yield, the highest level since 2012.
To this end, it is worth recalling the mechanism put forward by the ECB in the summer of 22’, the Transmission Protection Mechanism (TPI). The TPI, introduced to secure an orderly functioning of the market of sovereign bonds in the more fragile countries of the bloc, was a quick response to an almost Italy-specific turmoil affecting its sovereign bonds.
However, while it helped make the situation more controlled back then – meaning less prone to market-wide surprises and self-fulfilling reactions – by causing a narrowing of the spread to the benchmark by almost 1 percentage point, it may not be that useful this time around. That is because it is very unlikely that the ECB (following the program’s eligibility rules) will activate this mechanism if the need to do so comes from government-induced financial market distrust. And that’s exactly the case of what is going on.
The new wave of inflation fear, after the oil price shock, brought attached to it the so-called “bond vigilantes”, meaning that the bond market participants will be extremely watchful to fiscal policy decisions – i.e., to the actions of governments. The main episode of bond vigilantes in this long-lasting cycle came precisely one year ago in the United Kingdom. An overly expansionary budget presented by the then-recently elected new prime minister was enough to make her the shortest-ever (!) tenured prime minister.
Consequently, policies that go over the line of the market’s perspective of sustainability will be more painful than before. And Meloni surely knows about this: not only was she appointed days before the turmoil in the UK Gilts market, but also she saw from a privileged spot the power that the bond market can have in government’s destinies when the late Silvio Berlusconi was brought out of power, in 2011, with a big contribute of the enormous spread to the benchmark German bunds – as much as 570 basis points. This time around, there is not that much market distrust, but it is of major importance to keep an open eye on the financial markets. They can be very powerful.