Italy’s review by Moody’s may be more consequential than the US outlook change

While Moody’s took action on the US last week, a potentially more consequential decision looms this Friday when Italy’s rating is scheduled for review – it stands just one notch above junk and has been coming with a negative outlook since August last year.

The developments on the government’s fiscal policy have only since then as has been highlighted also by other rating agencies. A downgrade to junk would send a very bad signal and could push Italian sovereign bond spreads over Bunds wider above recent peaks of just above 200bp. From around 250bp onwards we would get to a slippery slope that could spiral into greater turmoil if the market is not getting reassurance from elsewhere.

For now that latter reassurance would have to come from the European Central Bank. The delay of the discussion to also shrink the pandemic emergency purchase programme’s portfolio and hints that the central bank wants to retain some of the flexibility to intervene in bond markets that it gets out of reinvestments also in the longer run has helped calm nerves.  

Helpful was also that both Fitch and S&P rate Italy one notch higher, with stable outlooks, and have chosen not to change their assessment over the past weeks when they had the possibility. Yes Moody’s acted on the US, but there it was only catching up. On Italy, Moody’s is considerably more aggressive than its peers, and it might not want to be seen as the one precipitating market turmoil by charging further ahead.  

Getting this final rating risk event out of the way may lead to calmer waters for Italian spreads, though we do not yet see reasons for a broader rally much tighter. The discussions for a new set of fiscal rules to replace the old Stability and Growth Pact are ongoing and bond markets still face the prospect of potentially faster quantitative tightening next year amid still overall elevated issuance.