Euro periphery bond update

The ECB cannot ignore market fragmentation.

The combination of market expectations for a faster and stronger ECB hiking cycle, the sharp slowdown in growth and the rise in sovereign bond yields has brought debt sustainability questions back onto the radar screens. The good news is that most countries have used years of extremely low rates to increase the duration of their outstanding debt, making them less sensitive to temporarily rising rates. However, a persistent rate shock has the potential to put the Italian debt to GDP ratio on an increasing path by 2030.

Barring a further and persistent 200 bp increase in BTP yields, we estimate that Italy’s public debt-to-GDP ratio should either stabilise (if yields move up by an additional 100 bp) or, in our baseline scenario, decline further towards 140% by 2030. We stick to our expectations of a tightening of the 10-year Italian spread vs the Bund from 195 bp (on 11 May) towards 160 bp by year-end.

Key to this spread-tightening view is also our expectation that the ECB will underdeliver on the rate path currently priced in by market participants, being constrained by both weaker growth and higher financial market volatility, while we expect euro area inflation to moderate slightly in H2. However, in the meantime, the 10-year BTP spread could continue to hover around 200 bp until the end of the summer, with market participants potentially testing ECB’s resolve to use the flexibility embedded in PEPP reinvestments.

As such, the ECB could well announce its readiness to use this flexibility at its upcoming meetings if periphery government bond spreads vs the Bund widen further. However, barring a sharp and broad-based increase in periphery spreads, we do not expect the ECB to announce a new stability QE facility. The bar is too high as the ECB focuses again on its primary mandate: fighting inflation.

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