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Is the Italian government sailing the country towards a cliff? Its latest three year economic plan included an increase in the Italian budget deficit through increased spending as well as including some highly optimistic estimates about the country’s economic growth.

The Armchair Trader was visiting Milan in July, and in meetings with Italian financial professionals it was made very clear to us that Italy is still a country with a massive north-south divide, starkly illustrated by the relative wealth of the north of the country versus the highly agricultural south.

Italian bond market heading for a cliff?

With a total debt level of 130% of GDP it does not require a very large fiscal expansion for some serious questions to be asked about Italy’s future role in the Eurozone. As part of the strengthening mechanisms put in place after the last Eurozone crises, all Eurozone countries signed up to a monitoring process that would oversee their fiscal plans. Brussels does not want to have to pony up for further bail outs on the level of the Greek crisis and wanted an early warning system in place that would allow it to monitor the budgets of the member states of the single currency.

This is leading to intense scrutiny on the Italian government’s budget planning and has led to a sell off in both the EUR and the Italian government bond market.

The next big date on the calendar is 10 October, when further detail regarding the budget will be released. If this is not in line with the projected three year economic plan the EU will not be happy with Italy, and nor will the ratings agencies. The big risk for Italy is a possible downgrade on the bonds: Italy is currently rated Baa2 with Moody’s with a negative outlook. A downgrade to Baa3 is looking likely, with a sustained negative rating. This would put the Italian bond market just one downgrade away from junk bond status.

“The implications of the world’s third largest bond market moving to junk are enormous,” says Sandra Holdsworth, Head of Rates and Fixed Income at Kames Capital. “The flight of capital from Italy would be vast.”

Things are looking very uncertain at the moment: Italy may be forced into changing its fiscal policy which would once again demonstrate how much political independence is really coughed up when a country joins the Eurozone. There may even be another election.

The European Central Bank’s hands are tied however: it cannot start QE again, it cannot cut rates and it cannot intervene unless the banking system is placed under undue stress. While Brexit continues to dominate the minds of European fund managers at the moment, issues with the Italian bond market will shake the entire European financial edifice to its very foundations, hitting the EUR and most European bourses.

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Stuart Fieldhouse

Stuart Fieldhouse has spent over 20 years in journalism and financial communications, including six years as a wealth management correspondent for the Financial Times group, covering capital markets and international private banking, and as an investment banking correspondent for Euromoney in Hong Kong.

Stuart has worked as head of content at CMC Markets, supporting the re-launch of its global financial spread betting and CFD trading platforms. He is also the author of two books on trading, published by Financial Times Pearson. Stuart continues to work with hedge funds, private banks, stock exchanges and other financial institutions on their communications, data and marketing requirements.

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