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At least two major banks have predicted that ratings agencies will lower Italy's sovereign credit rating to just one level above "junk" status.
Italy is at loggerheads with European commissioners over a proposed budget that would increase the country's deficit to 2.4 percent of annual economic output during 2019. The country's populist and partly right-wing coalition want the fiscal blow out in order to make good on pre-election pledges.
Brussels has rejected the plan, citing Italy's already huge debt pile. The clash has roiled markets, sending the yield spread between Italian and German 10-year benchmark bonds to a fresh five-and-a-half year high. Shares of the country's banking sector were also down 5 percent at one stage during Friday's session.
The uncertainty comes as two of the three major ratings agencies are readying reviews for Italy's sovereign credit rating, which currently sits at "BBB." S&P will decide on Friday October 26 while Moody's has said it will conclude its review before the end of the month.
Standard Chartered's rate strategist, John Davies, said Friday that his bank expected to see a one notch ratings downgrade. That would take Italy to just one level above a "junk" rating which would trigger forced selling of Italian assets. A ratings downgrade essentially means that analysts are telling clients that it has become riskier to lend money to that particular government and it often leads to a sell-off in those bond markets.
"The ratings agency induced pressure by the market will force Italy to back down," Davies said by phone Friday.
The strategist added that should Italy eventually bend to Brussels, this would "calm current nerves" and bring Italian yields lower. Davies warned however that the market won't bring yields all the way to levels last seen in May, before the political spat began.
"The market will still be looking at an Italy with a much less predictable government and a lower credit rating against a backdrop of fading ECB (European Central Bank) QE (quantitative easing) purchases," he added.
UBS is another bank predicting a ratings downgrade for Italy.
In a note Friday, the Swiss bank said its base-case scenario is for both S&P and Moody's to issue a one-notch downgrade, while tagging on a "stable outlook."
It said should such an outcome materialize, the spread between 10-year Italian and German debt — which is used as a fear gauge for euro zone troubles — should retreat from around 330 basis points back into a 250 to 300 range.
As the Italy budget row has continued, euro zone money markets have lowered their expectation that the European Central Bank will raise rates in September next year.
That month is seen as the first possible date that the ECB will raise rates after the bank themselves stated that there would be no change through the summer of next year.
The difference between the overnight bank-to-bank interest rate for the euro zone (Eonia) and its forward rates is now pricing a 75 percent chance that the ECB will raise its deposit rate by 10 basis points in September 2019. The markets had previously priced the September move in at 100 percent and, in effect now see only a 15-basis point rise in the deposit rate facility during all of 2019.
The deposit rate facility, which banks can use to make overnight deposits with the Eurosystem, currently stands at -0.4 percent. It is expected that when the ECB starts to raise rates, it will be this key rate that is raised first.
Standard Chartered's John Davies said while the change in pricing of the ECB rate trajectory is small, it is almost wholly related to the political spat over Rome's spending plans.
"The fact that the market is prepared to question it, shows how Italy can affect the market," he said.
European Central Bank president and Italian national, Mario Draghi, is poised to step down from his role at the end of October 2019.