Since the Italian government announced a 2.4 per cent deficit target for 2019, Italian sovereigns have once again been under severe pressure. Spreads against German 10-year bunds settled above the 300 basis points threshold for the first time since 2013, pulling down bank stocks and subordinated bonds. 
This was due to a significant deviation from the previous government’s target – which was to some extent expected – but also from the 1.6 per cent target announced by the finance minister himself earlier in September.
A market sell-off materialised ahead of rating agency reviews, with investors anticipating credit downgrades. However, spreads moved wider than a one notch downgrade could justify. Current Italian credit default swaps and bond spreads are 150 basis points wider than BBB-rated Portuguese bonds and wider even than some junk-rated emerging country bonds, where fundamentals are structurally poorer.
Market reaction to Moody’s downgrade was mild if not marginally positive, given the agency assigned Italy a stable outlook. Sticking to the rating-spread correlation, it is hard to imagine a different reaction to the Standard & Poor's review – even if it is negative. Only if the Standard & Poor's downgrades Italy into junk territory could we expect a stronger reaction, but it is difficult to imagine such a move before the outlook first becomes negative.
However, there is more to current pricing than rating expectations. And the government has not yet defaulted. With the yield curve positively sloped and no rate above 4 per cent, the market is not pricing any short-term default risk.
Populist rhetoric driving pessimism
So, what’s behind the spread? As trivial as it may seem, we think uncertainty is due to a mix of economic and political factors. While the economic deficit is not so worrying in itself, investor confidence in Italian GDP projections is low, hence markets have started to price in additional deterioration in fundamentals, especially the debt/GDP ratio.
The current spread is not much wider than at the end of June, when the budget was far from being released. Therefore, the political challenge to the EU is probably what drove investor concerns and lies behind the additional premium on Italian bonds.
If that’s the case, we hardly believe such uncertainties will dissipate anytime soon, unless the Italian government steps back. However, this won’t happen because of any direct actions or moral persuasion from the EU Commission or rating agencies. If anything, a government reversal on the budget would be driven by market pressure on spreads.
Whatever their campaign rhetoric, both the Five Star and the League cannot ignore the impact of higher financing costs not only on their budget forecast, but most importantly on bank balance sheets and, ultimately, on their electorate.
While most government officials keep a hard line against the EU, they have smoothed their tones on markets and let investors know they consider 400 basis points to be a critical level for spreads.
If we are right, things may get worse before they get better.
Antonio Ruggeri is manager of the OYSTER European Corporate Bonds fund at SYZ Asset Management. The views expressed above are his own and should not be taken as investment advice.