Italy's sovereign debt risk premium hits multi-month high ahead of budget

The gap between Germany's 2-year and 10-year yields was at -43.5 bps after hitting on Tuesday -41.30, its highest level since Aug. 26. An inverted curve, usually a reliable indicator of a future recession, means markets are pricing events which would lead central banks to cut rates.

Italian sovereign debt risk premium hit a multi-month high on Wednesday as investors adjusted their positioning to lower growth and higher deficit figures ahead of the budget plan. The Italian government will meet on Wednesday to set the framework for next year's budget.

It plans to raise its 2024 budget deficit target to between 4.1% and 4.3% of gross domestic product (GDP) from the 3.7% goal set in April, sources told Reuters on Monday. "Despite the choppy market backdrop, the 200 basis points (bps) level seems a high hurdle for BTPs in the absence of further fiscal slippage," Michael Leister, head of interest rates strategy at Commerzbank, said.

The gap between Italian and German 10-year yields – which is also a gauge of market sentiment towards the euro area's most indebted countries – was at 190.5 bps, after hitting 194.2, its highest since May 5. It rose above 190 bps for the first time since May on Tuesday. "The debate around the Italian budget will stoke volatility in Italian sovereign debt also because negotiations on the European new fiscal rules are entering a crucial stage," said Massimiliano Maxia, senior fixed income specialist at Allianz Global Investors.

European finance ministers are working to have a reform of the Stability and Growth Pact ready by the end of the year. The European Commission proposed to change the EU's fiscal rules to require governments to negotiate debt reduction paths of a length linked to reforms and investments. Some members, including Germany, remain sceptical.

If European countries exceed the deficit ceiling or expenditure limits, there will still be disciplinary steps, with smaller but swifter fines for breaches. "Any increase in cash deficit target for Italy today would mean higher funding needs, which might add to BTPs’ headwinds," Citi analysts said in a research note, adding they expect the Italian debt to remain under pressure.

The spread between French and German 10-year yields has been roughly stable in the middle of its recent range at around 55 bps ahead of the budget presentation later on Wednesday. German 10-year yields, the benchmark for the euro area, dropped 1.5 bps to 2.78% after hitting their highest level in over 12 years the day before at 2.821%.

The German yield curve hit its least inverted level since May 2022 on Tuesday as investors adjusted their positioning to a higher-for-longer rate scenario. The gap between Germany's 2-year and 10-year yields was at -43.5 bps after hitting on Tuesday -41.30, its highest level since Aug. 26.

An inverted curve, usually a reliable indicator of a future recession, means markets are pricing events which would lead central banks to cut rates. Lending across the euro zone slowed to a near stand-still in August, data from the ECB showed, as economic growth continued to falter and the bloc was skirting a recession.

European Central Bank officials have in recent days said policy rates will stay at the current levels for an extended period to tame inflation. They also flagged the chance of another rate hike after the central bank raised the deposit facility rate to 4%.

Economic growth is more sluggish than the ECB expected, but the goal is to control inflation, so interest rates could still go higher if needed, ECB board member Frank Elderson said. Market bets on ECB rates priced in an about 25% chance of a 25 bps rate hike by December.

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