Market Extra: Europe’s bickering over coronavirus bill spills over into Italian bond market

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Wild swings in the Italian government bond market is bringing back worries that weaker members of the eurozone will be unable to bear the fiscal hit from the coronavirus pandemic’s economic impact.

Borrowing costs for Italy’s government have remained elevated despite the European Central Bank’s increased purchases of bonds from the peripheral eurozone countries which suffer from more fragile public finances than, say, Germany and other Northern European states.

Part of the reason is that European leaders have struggled to reach an agreement on ways to share the burden of increased government spending, amid worries among Northern European countries that they will have to foot the bill. More fiscally conservative eurozone members have protested against the idea of so-called ‘coronabonds,’ which would distribute the cost of the coronavirus across the economic bloc.

Opinion: Macron faces uphill struggle to enroll EU on coronabond scheme

The failure this month of European leaders to agree a joint fiscal response of any meaningful size has reignited worries about the financial health of some eurozone governments, said Oliver Allen, assistant economist at Capital Economics, in a Thursday note.

See: Lagarde signals ECB keeping its powder dry as it braces for ’unprecedented decline’ in eurozone economy

The spread between the 10-year Italian government bond yield TMBMKIT-10Y, 1.772% and its equivalent German bond TMBMKDE-10Y, -0.588% stood at around 2.34 percentage points, well above the 1.32 percentage points at its February lows, Tradeweb data show. A wider spread shows when investors are demanding more yield in return for the increase in perceived risk from owning Italian debt.

The COVID-19 pandemic has strained the public finances of eurozone governments needing to borrow funds to cushion the economic damage from the current recession, while tax receipts have plummeted after businesses and consumers halted spending. As the economy with the second highest levels of government debt, those issues have only compounded Italy’s fiscal pains.

Trading in Italian government bonds have also seen a surge of volatility in recent days amid expectations that the economy’s credit rating would be downgraded to below investment-grade,or “junk.” The worry is the ECB may end its purchases of Italian bonds, removing a backstop of the country’s debts.

“The ECB has taken a lot of risk out of the market. If the ECB wasn’t there, spreads in Italy would easily be at 500 basis points right now. That would be commensurate with the fiscal risk and the risk of the EU breaking up,” said Ed Al-Hussainy, senior interest rate and currency analyst at Columbia Threadneedle Investments, in an interview.

But with rating agencies S&P Global Ratings and Moody’s Investors Service both indicating that downgrades are unlikely to take place in the near-term, investors are once again tackling the more fundamental fear that Italy could default on its debts, prompting bond buyers to demand higher interest rates to compensate for the risk of lending to the country.

Al-Hussainy says if politicians don’t come up with a solution, the ECB could buy new Italian debt straight from the public treasury of the Italian government.

Yet, investors are unlikely to see this move deployed after ECB President Christine Lagarde said at the post-meeting news conference on Thursday that the tool remained on the table, but suggested it remained a last resort.

“A lot of things have to go wrong for them to reach for that tool,” he said.

Read: Three years of eurozone economic growth wiped away as ECB’s Lagarde forecasts big drop for the year

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