Mario Draghi, during his eight years as president of the European Central Bank, developed a near-legendary ability to rein in the borrowing costs of eurozone governments. Investors appear to be giving him similar powers to Italy’s prime minister, judging from the calm that has gripped the region’s bond markets since he took office in February.
Italian bond prices soared, lowering borrowing costs, when Draghi switched from a former central bank widely credited with taming the eurozone debt crisis a decade ago to a politician. After a brief fluctuation in recent weeks, with investors increasingly concerned that the European Central Bank may soon start withdrawing its emergency stimulus, Rome’s borrowing costs are back to their lowest levels in a month.
Analysts at Goldman Sachs dubbed the former European Central Bank president’s power over bond markets the “draghi put.” “Italian sovereign risk pricing indicates confidence in Draghi’s ability to contain political risks,” the bank wrote in a note to clients last week.
Investors signaled their support for the Prime Minister’s plans to reform the Italian bureaucracy with €205 billion in EU recovery funds being spent. The all-important spread that Italy pays on its debt relative to the interest costs of Germany’s ultra-safe 10-year bond stands just over one percentage point, not much higher than the five-year low in February.
“There is definitely a view in the market that Draghi makes no mistake, that everything he touches turns into gold,” said James Athey, bond portfolio manager at Aberdeen Standard Investments.
Some fund managers feel there is a chance to pull Italy out of decades of low-growth hibernation. They are betting on the stability provided by Draghi’s National Unity Alliance which provides the perfect backdrop for the reform program as Italy publishes one of the largest shares in the EU’s €750 billion pandemic recovery fund. The government established a supervisory body to oversee the disbursement of funds, and introduced measures to simplify the bureaucracy and speed up infrastructure development.
This is exactly what Italy needs to address its long-term issues. “It’s targeted fiscal spending aimed at the right reforms,” said Gareth Colsmith, head of global rates at Insight Investments. “That’s why we are optimistic about Italy.”
The trend of Italian margins has repercussions beyond its borders. As the eurozone’s largest government bond market – and one of its most risky – Italy is setting the tone for riskier assets across the bloc. For now, the “Draghi effect” has helped cover concerns about Italy’s large public debt of more than 160 percent of GDP, according to Andrea Ignelli, investment director at Fidelity International.
Yanelli argues that this may be overly optimistic. Plans are one thing, but putting billions into investing could reignite old political struggles. There are some signs of discontent among voters, with the Italian anti-EU fraternity – the only major party not supporting Draghi’s coalition – currently in second place nationally after winning steadily in opinion polls.
“It won’t be easy,” Yanelli said. “Simple sailing is something the market has set.”
As a technocratic appointment, Draghi is not expected to continue as prime minister after the upcoming elections. The coalition’s mandate should expire by 2023, although a vote could come as soon as next year if Draghi decides to run for Italy’s presidency.
Markets may soon begin to worry about what may follow the Unity alliance, said Chiara Cremonese, fixed income analyst at UniCredit. “Investors are positive about Draghi, so they are clearly concerned about how long his government will last,” she said. She added that UniCredit does not expect elections in 2022, but “increased political hype” could push margins to the 1.2 percentage point level reached before Draghi’s arrival.
Even in the absence of a political outbreak, the relative calm in the markets depends on the European Central Bank and its continued support to the markets through the €1.85 trillion pandemic bond purchase program introduced by Draghi’s successor at the central bank, Christine Lagarde. The Eurozone bond sale in May, which widened Italian spreads while raising German yields, shows how sensitive markets are to any suggestion of an early “scaling back” of net purchases from the current rate of €80 billion per month.
Since then, a string of European Central Bank officials, including Lagarde, have reassured investors that they will continue their efforts at this month’s policy meeting. Investors believe that the European Central Bank will be particularly sensitive to any rise in Italian yields. As long as the former European Central Bank chief remains in office, some are betting that the central bank will likely keep the stimulus taps on.
“As long as they believe Italy is doing reasonable reforms, they will continue to provide support,” Colsmith said.