A Big Week Looms, Politics & ECB Tool Eyed

Italian politics will once again be eyed early this week, after PM Draghi’s attempted resignation (which he is set to cement on Wednesday, per MNI & wider press source reports) allowed the BTP/Bund spread to move comfortably back above the 200bp mark, closing last week at ~215bp.

• The weekend saw the leaders of the League & Forza Italia (on the right hand side of the Italian political spectrum) note that the government alliance backing Draghi has been broken, which could flag the onset of preparations for an election (late September is the earliest time that such an event could take place) as the parties ruled out remaining in government with the M5S party. A reminder that a coalition of parties on the right of Italian politics are expected to form the government in the wake of any such elections, based on the current opinion polls.
• When it comes to monetary policy, the ECB is expected to conduct its first rate hike in over a decade later this week (consensus looks for a 25bp move, on the back of prior ECB guidance). The aforementioned Italian political headwinds will put pressure on the ECB after it expedited the development of an anti-fragmentation tool as it looks to prevent transmission issues while it normalises monetary policy.
• A reminder that MNI sources have suggested that the large remaining differences within the ECB re: the design of the tool will be difficult to resolve by this week’s meeting, but officials will aim to convince markets that the tool has major firepower even if some of its details are never made public (hoping that its mere presence will do most of the heavy lifting for the Bank)
• Looking at wider expectations surrounding the anti-fragmentation scheme, the latest BBG survey revealed that ~89% expect unlimited size, ~90% expect light or no conditions at all and ~21% expect sterilisation to factor in via the ECB selling other bonds from its portfolios (89% look for sterilisation via liquidity-absorbing ops).
• Note that at ~215bp the BTP/Bund spread operates ~30bp off its YtD wides and remains below its COVID/Lagarde “we are not here to close to close spreads” ’20 peak, and well shy of the peak of the “Salvini spike” that was witnessed in ’18. This comes after the extraordinary meeting that outlined the expedited development of the anti-fragmentation tool, coupled with wider recession-based fears, a pullback in pricing surrounding the speed/terminal rate of the impending ECB tightening cycle and mid-June comments from Bank of Italy Governor Visco (flagging 150bp as a level that would be “justified” by fundamentals when it comes to the spread, while deeming anything over 200bp as unjustified) allowed the spread to compress.
• The ECB has already had to act once after disappointing markets on this matter (see last month’s extraordinary meeting) and will not want to disappoint markets again, although the aforementioned wider expectations and inhouse doubts provide non-negligible complications.

Fig. 1: 10-Year BTP/Bund Spread (%)

Source MNI - Market News/Bloomberg