LONDON – A Franco-German proposal for a half-a-trillion euro recovery fund has lifted Italian bonds and the common currency, but investors say the effect may wear off soon once sceptical Northern European countries get their say.
Bond investors have long hoped for some form of joint financing to tackle the costs of fighting the coronavirus pandemic, which has hit heavily indebted Italy particularly hard.
Italian bonds rallied and the closely watched risk premium Italy pays on its debt fell to its lowest in over a month at 208 bps IT10DE10=RR at news of the proposal, which would see the funds offered as grants rather than loans that might add to Italy’s debt burden.
But investors are expecting more market volatility ahead until an agreement is reached, given the rift between the fiscally hawkish northern EU countries and the southern members looking for liability sharing.
A group of European Union states opposed to big spending by the bloc will present a counter-proposal to the Franco-German one, Austrian Chancellor Sebastian Kurz said on Tuesday.
“There are a lot of hurdles they need to get over before any cash gets distributed to those peripheral (states) that really need them,” said Nick Sanders, a portfolio manager at AllianceBernstein, who said he took some profits from his overweight position on Italian bonds following Monday’s rally.
“Markets reacted rightly strongly yesterday but I think we will see additional negative headlines…and volatility.”
The package is highly likely to be watered down to appease the hawkish states, Rabobank analysts told clients, warning that this could potentially lead to a portion of the recovery fund being provided in the form of loans, rather than grants.
In a recent fund manager survey by BofA, investors saw the potential break-up of the euro area as the third biggest risk for financial markets after a second wave of coronavirus infections and permanent unemployment.
In the short-term, the most crucial factor driving Southern European borrowing costs will remain the European Central Bank’s emergency bond purchases, investors told Reuters.
Markets expect that the bank will scale up purchases at its meeting on June 4, so a failure to do so could push Italy’s borrowing costs back up again.
“Whether it likes it or not, the ECB will be the principal setter of bond prices in European fixed income for the foreseeable future,” said Mark Dowding, chief investment officer at Bluebay Asset Management.