Italy’s Sovereign Bond Market Is Resilient to Gradual Quantitative Tightening

The ECB’s accommodative monetary policy was instrumental in ensuring highly favourable financing conditions for Italy, especially during the Covid-19 pandemic. Now, however, high inflation points to a turnaround in this monetary policy stance, although the ECB will have to contend with significant economic ramifications of Russia’s further invasion of Ukraine on inflation and growth in Europe.

In its March meeting, the ECB confirmed its decision to halt net asset purchases under the Pandemic Emergency Purchase Programme (PEPP) this month and communicated its readiness to also halt net asset purchases under the Public Sector Purchase Programme (PSPP) in the third quarter if the medium-run inflation outlook does not weaken.

The latest ECB decisions signal that monetary policy normalisation could happen faster than the ECB previously expected. Even in this updated scenario, our estimates of ECB asset purchases and Italy’s funding needs signal that the ECB’s role in the Italian bond market will remain supportive through the reinvestment phase, likely limiting the amount of annual bond issuance to be absorbed by private investors to below or in line with historical peaks.

Italy government debt, by holding sector

ECB quantitative easing has supported demand for Italian government debt

PEPP and PSPP have supported demand for Italian government bonds in the secondary market, lowered borrowing costs for the Italian Treasury and resulted in a large transfer of government debt to the central bank balance sheet. Net asset purchases have been so significant as to even reduce the amount of Italian debt held by the private sector.

Annual asset purchases of Italian government securities by the ECB – including net purchases and the reinvestment of maturing principal – are set to decrease from about EUR 180bn in 2021 and EUR 210bn in 2020 to around EUR 90bn this year on current projections. This would result in the annual volume of long-term issuance that needs to be absorbed by financial markets reaching approximately EUR 215bn this year, which is significantly above our estimates for 2020-21, but still under levels of 2019 of circa EUR 225bn.

The ECB’s supportive role will remain material also over the following years, thanks to continued reinvestment of its maturing debt holdings. This will likely curtail the volume of annual long-term issuance by the Italian Treasury absorbed by financial markets to below or in line with 2014 levels of EUR 272bn over forthcoming years, limiting pressure on the financing costs of Italy.

Pressure on households and banks to absorb government securities is likely to emerge

Nevertheless, pressure on the capacity of households and the banking sector to absorb government securities is likely to emerge in the longer run in lieu of significant fiscal consolidation.

Such annual volume of issuance would need to be absorbed under a context of a rising outstanding stock of debt held by the private sector over time.

We estimate that so long as PSPP reinvestment continues, debt securities corresponding to a deficit of about 2.5% of GDP could be absorbed by the ECB. Without such reinvestment, the private sector would need to absorb the highest annual levels of Italian issuance to date, even assuming a balanced budget for the government, which is not our base case.

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Alvise Lennkh is the Deputy Head of Sovereign and Public Sector ratings at Scope Ratings GmbH. Giulia Branz, Analyst at Scope Ratings, contributed to writing this commentary.