Italian bonds rally after Moody’s credit rating reprieve

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Italian bonds rallied on Monday after Rome avoided a potential downgrade of its credit rating to “junk” status, in a boost to Prime Minister Giorgia Meloni’s right-wing coalition government.

Moody’s affirmed the country’s investment-grade rating in a scheduled update after markets closed on Friday, and raised its outlook for the country’s debt from negative to stable.

The resulting rally in Italian bonds pushed 10-year yields down 0.04 percentage points to 4.32 per cent, the lowest since early September. The closely watched spread between Italian and German 10-year bond yields — a gauge of the perceived risk in Italy’s debt — narrowed to just over 1.7 percentage points on Monday morning, the lowest level since late September. 

The spread — which is considered an indicator of stress in European financial markets — had surged back above 2 percentage points in October over concerns about Italy’s rising budget deficit plans and its weakening economic growth.

Moody’s cited the “stabilisation of prospects for the country’s economic strength, the health of its banking sector and the government’s debt dynamics” as it chose not to become the first of the main rating agencies to strip Rome of investment-grade status.

The agency also expressed optimism that Italy’s medium-term growth would be supported by the implementation of its €200bn, EU-funded post-pandemic reform and investment programme, despite Rome’s proposal of considerable revisions to the scheme.

Moody’s rates Italian sovereign debt at Baa3, one notch above junk, and lowered its outlook to negative in August 2022 after the unexpected collapse of a national unity government led by Mario Draghi, the former European Central Bank president, sent the country hurtling into early elections. 

However, since taking power just over a year ago, Meloni has sought to reassure international investors that her rightwing coalition would be responsible stewards of Italy’s economy and pursue fiscally prudent policies as she distanced herself from her past populist, anti-EU rhetoric.

Moody’s restoration of Italy’s stable outlook is a welcome boost for Rome at a time when it is wrestling with weakening European growth and much higher funding costs following a cycle of interest rate rises to combat inflation.

“It is incredibly good news for Meloni’s government as it creates a lot of breathing room for her politically and economically,” said Mujtaba Rahman, managing director in Europe for the Eurasia Group, a consultancy, 

Giancarlo Giorgetti, Italy’s finance minister, said the decision was “confirmation that, despite many difficulties, we are working well for the future of Italy”.

Analysts at Citigroup predicted in a note to clients on Monday that the spread between Italian and German bond yields would “tighten on the relief” of Moody’s decision “and then stabilise into December” as the Italian government reduced its bond issuance.

Italy’s lower cost of borrowing would also benefit Italian banks, the Citi analysts said, by reducing their funding costs. 

Italy’s government debt has risen above 140 per cent of its gross domestic product — the second-highest level in the EU after Greece — driven by higher spending to tackle the fallout from the coronavirus pandemic and the energy crisis caused by Russia’s invasion of Ukraine. 

Meanwhile, the country’s economic rebound from those shocks has lost momentum this year, with third-quarter GDP flatlining from the previous quarter and from a year ago.

However, the outlook for Italy has brightened recently thanks to a sharp drop in inflation, which fell to the lowest level for more than two years in October, combined with rising investor hopes that the ECB could start cutting interest rates as early as next spring. 

The central bank has also supported Italian bond markets by maintaining reinvestments in a €1.7tn portfolio of mostly government debt it started buying in response to the pandemic, despite calls from some policymakers to end this before the end of next year.