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Italy's bonds, banks and equities boosted by budget breakthrough

Key Points
  • Italy's bonds, banks and equities boosted by a budget breakthrough with the EU Wednesday.
  • The FTSE MIB is trading 1.85 percent higher and Italian bond yields also fell.
  • Italy and the EU had fallen out over Italy's 2019 spending plans.
Rome, Italy
Sylvain Sonnet | The Image Bank | Getty Images

Italian equities and bonds were given a much needed boost on Wednesday after it was confirmed that the Italian government has struck a deal with the European Commission over its 2019 spending plans.

Italy's FTSE MIB index was trading 1.85 percent higher on Wednesday early afternoon with the country's bank stocks trading around 2.5 percent higher. Italian bond yields also fell, with the yield – or interest rate – on a two-year bond at its lowest level in almost seven months (at 0.395 percent). The yield on benchmark ten-year bonds slipped 12 basis points to 2.81 percent Wednesday.

The Italian/German 10-year bond yield gap - an indicator of perceived risk - narrowed to 261 basis points, the narrowest since September. Investors demand less interest on government bonds if the perceived risk of holding those bonds decreases and news of a breakthrough in Italy's budget tussle with the European Commission has buoyed investor spirit.

The market boost comes amid a deal between Italy's coalition government, made up of the right-wing Lega party and anti-establishment 5-Star Movement, and the European Commission over the country's controversial 2019 spending plans.

Italy's government said last week that it would aim to lower its deficit target to 2.04 percent, down from an original target of 2.4 percent, and that amount was confirmed by the Commission Wednesday.

Barclays's senior European economist Fabio Fois said in a note Wednesday that "a settled relationship between Rome and Brussels ahead of European elections reduces the risks of rhetoric escalating and with that the redenomination narrative," but he didn't rule out future skirmishes with the EU.

"Absent a change in the current ruling political equilibrium towards a more growth friendly one, we do not rule out tensions between Italy and European authorities resurfacing going into the second half of next year," he said. The Commission itself said Wednesday that although it had accepted revisions to Italy's budget, it would keep a close eye on the country's spending and that, for now, Italy had avoided any disciplinary action.

"The solution is not ideal," the Commission's Vice President Valdis Dombrovskis said Wednesday in a statement to reporters, "but it allows us to avoid an 'Excessive Deficit Procedure' at this stage … One important positive element is that the new budget is based on a plausible economic scenario," he said. Charles Dumas, chief economist at TS Lombard, told CNBC's Street Signs that Italy seemed to have done just enough for now to reassure markets.

"It's been quite a rollercoaster for Italy since this government was formed and the thing about Italy is that there's an equilibrium level for the spread but it's on a see-saw and … what we've seen is that this government has come in, it starts talking about aggressive fiscal stimulus well ahead of the EU's guidance and as a result the market reprices (Italy) very aggressively."

"How far they come back from that before markets are reassured seems to hinge on whether there's an 'excessive deficit procedure' or not, and it looks like they've moved just far enough to do (reassure markets of) that," he said.

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