Markets: News  

Italy shakes off downgrade, but fears mount

FRANKFURT (MarketWatch) -- Italy dodged a potentially unlucky Friday the 13th, easily selling a batch of new three-year bonds in a closely-watched auction that came just hours after Moody's Investors Service cut the country's credit rating by two notches.

But high borrowing costs, jitters over Spain and Greece, and growing signs that scandal-plagued former Prime Minister Silvio Berlusconi may be plotting a comeback could make any relief short-lived.

"Italian government debt remains under considerable pressure. Practically nothing was done at the last European Union summit to help shore up the Italian sovereign," said Nicholas Spiro, managing director of London-based Spiro Sovereign Strategy, an advisory firm, referring to a late June meeting of European leaders.

Italy's Treasury sold 3.5 billion euros ($4.3 billion) of new three-year bonds. The sale produced an average yield of 4.65%, down from a level of 5.30% in a sale of three-year securities last month. Italian yields have retreated somewhat since the EU summit.

Italian bonds sank early Friday after Moody's cut the country's credit rating to Baa2 from A3 and left Italy on negative outlook. That drop in price likely helped ensure Italy's Treasury got the issue out the door, said Nick Stamenkovic, fixed-income strategist at RIA Captial in Edinburgh.

A generally risk-positive environment in the wake of a less dire-than-feared round of Chinese economic data also helped, analysts said.

Italy's borrowing costs remain high by any measure. The yield on the 10-year Italian government bond (10YR_ITA) traded at 5.97%, up 0.08 percentage point, according to electronic trading platform Tradeweb.

The credit-default-swaps market had little lasting reaction to the data. The cost of insuring Italian government debt against default using the instruments initially rose, but soon fell back in the wake of the auction results, according to data provider Markit.

"Italy is more likely to experience a further sharp increase in its funding costs or the loss of market access than at the time of our rating action five months ago due to increasingly fragile market confidence, contagion risk emanating from Greece and Spain and signs of an eroding non-domestic investor base," Moody's said, in a statement.

The ratings firm also noted that the country's near-term economic outlook has deteriorated as reflected by weaker growth and higher unemployment. That will make it harder for Italy to meet its deficit targets, which could serve to further erode market confidence.

The downgrade drew objections from Italy's government. Industry Minister Corrado Passera, speaking at a conference in Rome, called it "altogether unjustified and even misleading," according to Reuters.

However, Gavan Nolan, director of credit research at Markit, said the lack of lasting market reaction to the downgrade showed that the Moody's move was "misleading" for a different reason than implied by Passera.

"A Baa2 is misleading because the CDS market indicates that Italy deserves a far worse credit rating," Nolan said, in a note. "The sovereign trades with an implied rating of single B, according to Markit data, and has done for some time." As a result, the issues highlighted by Moody's "didn't exactly come as a shock to the market," he said.

Economists at Barclays, however, called the ratings move "somewhat perplexing." So far, early elections appear unlikely with major parties still supporting Monti's government, they noted. And while contagion risks remain, they argued that recent moves to shore up Spain and the aftermath of the Greek election provide some stability to the euro zone.

Also, Italy posted a primary surplus -- its budget balance excluding interest on outstanding debt -- of 1.2% of gross domestic product at the end of the first quarter, they noted, up from 1% at the end of 2011. They also argued that Monti's structural reforms could have a positive impact on long-term growth, providing more confidence about the sustainability of government debt.

Analysts said Italy's got little room for error.

While Prime Minister Mario Monti, who heads a technocratic government made up largely of non-politicians that is backed by the country's major parties, has wrestled to introduce a range of labor-market reforms, many of the measures have been watered down to assure passage.

Also, while Spain has already met nearly half of its funding needs for the year, Italy remains behind the curve. With international investors increasingly wary of peripheral euro-zone debt, Italy could easily see another spike in borrowing costs in the event of a negative domestic economic surprise or a shock from within the euro zone.

A move back toward the 7% level for Italy's 10-year government bond yield would spur speculation Rome could be forced to request help from the euro-zone rescue funds, including the €500 billion European Stability Mechanism, or ESM.

The ESM, which is meant to be the region's permanent rescue vehicle, has been delayed. That is due in part to a Constitutional Court challenge in Germany, where judges have said they may not issue a decision for up to three months after a hearing earlier this week.

The temporary European Financial Stability Facility holds around €100 billion in its coffers after the Spanish bank bailout, noted Tobias Blattner, an economist at Daiwa Capital. As a result, the prospect of interventions by the rescue funds in secondary bond markets, which were hailed as a breakthrough by Monti at the EU summit last month, are off the table for now, he noted.

That puts the burden of keeping yields from going through the roof in the event of a sharp deterioration in market sentiment on a reluctant European Central Bank, Blattner said.

Meanwhile, news reports say Berlusconi's longtime political allies are increasingly speaking of the former premier, who left office in November amid a string of sex and corruption scandals, making a political comeback, potentially running in 2013.

Monti has said he won't serve beyond the end of his current term.

"The credibility and confidence that Premier Mario Monti helped win back is in danger of being lost again…The risk is that investors start to fret about a more unstable and populist 'post-Monti' political landscape in Italy," Spiro said.