Italy is in trouble once more.

The 10-year Italian bond (BTP) yield has risen 80 basis points to 3.55%1 since late last month on news that the country’s draft budget plan (officially sent to the EU Commission on Oct. 15) has a deficit target of 2.4% of GDP (gross domestic product) for 2019.

At one level, this should not be surprising. A coalition pairing of the right-wing populist Lega Nord (League) party and the left-wing populist 5-Star Movement (M5S) party was never a recipe for stability, in our view.  Why? Both had promised a fight with European Union leaders in Brussels over fiscal rules and both campaigned on unaffordable promises. Markets were initially calmed by the appointment in June of the fiscally conservative economics professor, Giovanni Tria, as finance minister. This created the impression that the new government would not be too fiscally irresponsible—an idea which has since largely gone by the wayside.

The BTP yield at 3.55% may look attractive, especially considering it’s above initially calmed when the coalition government was formed. There are still, however, several issues that we believe need more clarity before we can be confident the worst is over:

  • Will Finance Minister Tria resign? Tria had been frequently reported in the press in the lead-up to the draft budget announcement as favoring a 1.6% of GDP deficit.2 The 2.4% deficit is a challenge to his credibility.
  • Do the ratings agencies downgrade Italy further? Moody’s has Italy on negative outlook and will report later this month. Moody’s expectation was a 2.1% deficit—less than the current proposed budget. Already, it’s rating of Baa2 is just two notches above sub-investment grade. 3
  • How much latitude will the European Commission allow Italy? The draft budget was submitted on October 15, and is currently under review. It’s unlikely, in our view, that the EU will allow a deficit larger than 2% of GDP.
  • Will politics push Italy to the fiscal brink? M5S is losing political support, while League is gaining support on its anti-immigrant platform. We think M5S may push to retain the larger deficit target to fund its expensive universal income scheme.
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