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Italy’s Supercharged Bond Market Is All About Faith in the ECB

(Bloomberg) — One of Europe’s riskiest bond bets is turning into a telltale sign of how much faith investors have in the central bank’s ability to engineer a smooth recovery out of the pandemic.

Italian benchmark yields are near a six-month low and the government is so flush with cash that it canceled last week’s debt auction. The market is beginning to look like a crowded trade, with the number of outstanding positions in bond futures at the highest since March.

It’s the latest evidence of the bullishness that’s swept across European markets. Italy is among the region’s most indebted nations yet has seen borrowing costs crater thanks to unprecedented stimulus from the European Central Bank that is quashing volatility and driving investors into the highest-yielding corners of the market.

“The PEPP extension could be crucial in that regard,” said Christoph Rieger, head of fixed-rate strategy at Commerzbank AG, referring to the ECB’s pandemic bond-buying program, which is scheduled to end in March, but which many investors are now betting will get prolonged.

Against this backdrop, Rieger expects Italy’s 10-year yield premium will fall to 75 basis points over its German counterpart — the region’s paragon of safety — from around 100 basis point currently.

Meanwhile, Italian stocks are on tear after a blockbuster earnings season in Europe, and the ECB recently tweaked its forward guidance to signal a longer period of ultra-loose policy, adding fuel to the rally.

Last week, the number of outstanding Italian 10-year bond futures contracts rose by about 60,000 to over 360,000. The increase came as the underlying securities rallied, which suggests investors are adding to rather than trimming their positions into strength.

Still Giles Gale, head of European rates strategy at NatWest Markets Plc, is beginning to consider what could happen if everyone rushes for the exit at the same time.

“It would be perverse, but possible in this market,” he said. For now, he also expects the Italian-German bond spread to narrow to 75 basis points in the coming months.

Meanwhile, Rohan Khanna, a strategist at UBS AG, points to the risk of snap elections, which he says are “highly likely” in the first quarter of 2022 if Mario Draghi decides to run for president, adding however that the odds of that are low.

But for now, all that seems like a distant possibility.

On Wednesday, Italy paid less than the ECB’s own deposit rate to borrow for 12 months for the first time ever. It’s an anomaly that highlights the scale of the distortion in the region’s money markets as well as traders’ bullish predisposition.

“An ECB which is in vol-control mode, extending its QE program for longer with an explicit commitment to financial stability, is clearly supportive for sovereign spreads,” Gale said.

This Week

Euro area and German data is thin next week and mostly relegated to backward-looking or secondary figures; the U.K. is busier with employment, inflation, retail sales and the latest government borrowing numbersIn another light week for supply, Germany sells 7 billion euros ($8.25 billion) of new two-year debt and a 30-year note, while France also auctions the same size of bonds. The U.K. will auction 2 billion pounds ($2.77 billion) of 25-year gilts.

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