Morgan Stanley Says Italy Bond Rally Is Over

Italy’s bond risk premium will surge back to levels seen at the start of 2023, according to Morgan Stanley strategists.

(Bloomberg) — Italy’s bond risk premium will surge back to levels seen at the start of 2023, according to Morgan Stanley strategists.

The euro area’s weakening economy, a lack of foreign demand and the potential for increased bond sales by the European Central Bank will weigh on the assets, they said. The rally has already stalled over the past couple of months, with Goldman Sachs Group Inc. betting against the debt as it sees Italy’s fiscal outlook “under pressure.”

“We now expect higher fiscal deficits and weaker growth,” Morgan Stanley strategists including Eric Oynoyan and economist Chiara Zangarelli wrote in a note. “In a context of a fast-weakening euro zone economy, that repricing should accelerate over the coming months.”

Italy’s bonds have long been considered among the region’s riskiest given the government’s large debt pile. Waning appetite for the securities is telling of the fiscal challenges now facing the euro zone after years of largess. Policymakers will also be taking note, having vowed to keep borrowing costs from deviating across member states unnecessarily.

The bonds, known as BTPs, are still outperforming peers this year. That reduced the yield spread between 10-year notes and their German bund equivalents — a widely followed risk measure — by almost 60 basis points to below 160 in June. Morgan Stanley now forecasts the gap will widen back to 210 basis points by the end of the year. 

“The supportive factors that allowed the 10-year BTP-bund spread to reach our 160 basis points bull case scenario have vanished,” the strategists said.

Italy’s budget is suffering as the economy shrank 0.4% in the period from April to June. A deficit may end the next year closer to 4%, further away from the 3% limit imposed by the European Union.

Read more: Meloni Tempts Bond Vigilantes With Italian Spending Squabble

Morgan Stanley says next year’s budget discussions will be “complex” as the government tries to deliver on electoral promises at a time when it is also expected to prioritize fiscal consolidation. The bank revised down its growth forecasts to 0.8% both in 2023 and 2024, well below the government’s predictions for 1% and 1.4%. 

Meanwhile domestic investors’ appetite for the debt has been stalling and there are no signs of a bounce in foreign demand. Morgan Stanley also expects ECB policymakers in December to announce the end of reinvestments in its pandemic emergency purchase program, under which Italy has been one of the biggest beneficiaries.

Goldman Sachs sees the recent slowdown in the European economy starting to show in the country, led by a reduction in construction activity that was previously fueled by “generous” tax credits introduced in 2020. 

“We expect renewed investor attention on Italian debt as European governments are working on 2024 budgetary plans,” Goldman Sachs economist Filippo Taddei wrote in a note. “Our market strategists maintain a widening bias in sovereign credit, especially in BTPs, which are likely most exposed to a change in sentiment.”

(Corrects headline and lead to show Morgan Stanley expects the outperformance to end, not the rally.)

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