Although they continue to be volatile, Italian spreads have dipped below 300 basis points in recent days amid speculation that the country’s government may be willing to cut a budget deal with the EU. Indeed, according to Fathom’s proprietary indicator, the market-implied probability of a default by the Mediterranean sovereign edged down to 14.8% in November.
As Fathom noted to clients last week, the market’s initial reaction to the coalition’s fiscal plans had perhaps caused Italian bonds to overshoot relative to their fundamental value.
However, with Italy’s debt-to-GDP ratio still above 130%, there remains a risk that a significant and sustained fiscal expansion could see the country’s already elevated level of debt spiral out of control. Added to this, analysis carried out as part of Fathom’s latest quarterly forecast suggests that, as the pool of public debt grows, fiscal policy becomes far less potent.
Default is by no means a guaranteed outcome — Belgium, a fellow euro area member state previously hampered by elevated debt, managed to bring its public finances under control prior to the global financial crisis. It achieved this through a mixture of fiscal restraint, falling bond yields and solid GDP growth.
The challenge may be greater for present-day Italy, which has a near-zero trend rate of growth and faces the prospect of a US-led recession in 2020. That being said, the government continues to benefit from relatively cheap funding costs with bond yields close to 3% — significantly below their long-term average.
Fathom’s latest forecasts for GDP, inflation and policy rate are now available through Datastream from Refinitiv.
 A separate proprietary indicator shows the market-implied probability of a euro exit also fell (from 14.5% in October to 13.5% in November).
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