In July 2011 an unusual fascination had gripped some members of New York’s financial community. Walk into a Manhattan office expecting to discuss the US stock market with an investor who exclusively backed equity hedge funds, and they instead had Italian government debt on the brain.
Selling short bonds of the eurozone’s third-largest economy had become so popular that non-debt specialists had started to notice, and rising borrowing costs for the Italian government were a sign of a spreading crisis which was to entangle several European nations and their banks, ultimately threatening the future of the euro.
Turbulent politics — a coalition government fighting itself over austerity plans and corruption allegations — were colliding with the hard economics of Europe’s largest pile of sovereign debt.
Almost six years later a caretaker government is in charge after Matteo Renzi resigned as prime minister in December, and the populist Five Star Movement leads in opinion polls. Benchmark 10-year bond yields are also rising again, albeit from much lower levels: 1.74 per cent at the start of the year to 2.36 per cent on Monday.
The question for bond investors with long memories is why, and how much further the rise can go, as higher market yields push down the value of existing bonds offering coupon payments fixed at the time of issue.
A benign explanation would be the worldwide rise in interest rates since Donald Trump was elected US president in November. Economic conditions are improving across Europe, including Italy, and signs of inflation could prompt changes to the monetary policies which dictate borrowing costs.
The European Central Bank will in April cut the amount of bonds it buys each month to €60bn, from €80bn, and many investors have begun to debate how soon further reductions are made in a programme designed to suppress the interest rates paid by governments and businesses across the eurozone.
John Wraith, interest rate strategist for UBS, says he expects an announcement of further reductions, a so-called tapering of asset purchases, as soon as September, and markets have already begun to anticipate the effects.
The difference, or spread, in Italian and German bond yields reached its largest in three years this week, at 2.02 percentage points according to Tradeweb. German debt is considered the safest in Europe, while concerns remain about the sustainability of Italy’s debt pile.
“The ECB has been able to make these questions go away by squeezing spreads,” says Mr Wraith.
Yet some argue higher yields haven’t been caused by the prospect of less stimulus, meaning moves are despite ECB policy.
Erjon Satko, a strategist for Bank of America Merril Lynch, points to the market for credit default swaps, a form of financial insurance. In theory the difference in prices for CDS and cash bonds should be minimal, as both reflect an assessment of a country’s ability to meet its obligations, and in 2013 and 2014 this was largely the case.
ECB bond buying caused prices for CDS and debt to diverge. If the idea is policymakers’ influence on bond prices is diminishing, the gap should shrink, but so far it has not.
Instead movement in Italian yields, says Mr Satko, “is on the back of domestic politics. You look at the Italian political system, at the next election you will have a very split government, where taking decisions is very difficult.”
It may be that upcoming elections in France, where a promise by far-right candidate Marine Le Pen to take the country out of the euro, has attracted more investor attention for now. But Italy may come into focus once a French president is elected in May.
“I’m more concerned about Italy than France,” says Andrew Bosomworth, head of German portfolio management for Pimco, a bond investment house.
Eurosceptic parties include not just the Five Star Movement, but also the Northern League, the Brothers of Italy and even the party of former prime minister Silvio Berlusconi.
Swelling antipathy is a concern for investors, says Mr Bosomworth, due to “the economics behind it, the low growth which makes the position in the eurozone less sustainable”.
Once inflation and population changes are adjusted for, the Italian economy has not grown since it joined the euro in 1999. The unemployment rate of 11.9 per cent is also broadly unchanged from 1998, while levels of youth unemployment and bad loans held by banks have risen.
A weaker currency might help, but is a remedy unavailable to members of the euro. Higher borrowing costs, meanwhile, compound the problem for a country where debt is more than 1.3 times annual economic output.
For now, banks report comparatively few investors actively shorting Italian debt, which requires borrowing bonds and so paying expensive interest payments to the owners. Investors don’t necessarily need to bet against Italian bonds for it to push yields higher, however, if many simply prefer to go elsewhere.
Jim Leavis, head of fixed income at M&G Investments, says “Italy has been the biggest beneficiary of quantitative easing”, and the only Italian government bonds he chooses to own at the moment mature this year. “I don’t think I have any edge in understanding the Italian political outcome,” he says.