Moody's cuts Italian sovereign debt to one notch above 'junk', but outlook 'stable'

Moody's downgraded the long-term rating on Italy's sovereign debt on Friday, arguing that the government's revised medium-term budget plans will fail to lift the country's low growth and leave it vulnerable to future fiscal shocks.

The ratings agency lowered its rating for Italy from Baa2 to Baa3, or to just one notch above so-called "junk".

However, it changed its outlook on the same from "negative" to "stable", with some market commentary arguing that the latter decision might cheer investors - to a degree - in so far as the risk of a downgrade to 'junk' even in the very short-term now appeared to fade.

Had Moody's instead kept the outlook at "negative", then that might have led to an even larger acceleration in investors' positioning against an eventual potential fall into 'junk' which, if accompanied by a similar move from other top rating agencies, might presage an eventual exit by the many institutional investors who, by mandate, are only allowed to invest client funds in debt rated "investment-grade" by at least two of the main ratings agencies.

"The Italian government’s significantly higher budget deficit targets for the next three years will keep its public debt at a high 130% of GDP, a level that makes Italy vulnerable to future economic shocks. Despite a short-lived boost to growth from fiscal stimulus, the government’s economic plans will not allow it to tackle the country’s low growth, which will move back to the trend rate of 1% at best," Moody's said in a statement.

To take note of, benchmark 10-year Italian government bonds (BTPs) rallied hard on Friday, with their yield falling by 20 basis points to 3.48%. Bond yields move inversely to prices.

According to Erik F. Nielsen, chief economist at UniCredit Group, the move in Italian debt followed the first signs of "contagion" from Italy to the debt of other euro area periphery nations and some semi-cores, especially Spanish debt.

Nielsen said the correlation between Italian and Spanish debt was likely the result of a negative ruling from Spain's Supreme Court for the country's banks the day before.

"But the ripple effects hit other countries as well, including Portugal and Belgium. If we have entered a period of more broad-based contagion, it’ll clearly increase the probability of a policy response by the ECB and other European policymakers to the turmoil, which started in Italy some six months ago," Nielsen said.

The rally in BTPs also came on the heels of a call from the European Union's Economics czar, Pierre Moscovici, for a calm dialogue with Rome. It also followed a report in local daily Il Foglio that the Italian government might be willing to reduce the planned budget deficit for 2019 from 2.4% of gross domestic product to 2.1%.

That report was later denied by Italian deputy Prime Minister, Luigi di Maio, but according to Nielsen "if it were to be confirmed, it would be very positive news for the market."

In any case, the size of the rally in Italian BTPs left Nielsen scratching his head, with the economist telling clients "the rally was completely disproportionate to the news available at the time, so I’m not sure what happened there."

Significantly, while Nielsen was critical of the details of Rome's new budget plans, he was scathing in his criticism of European regulators' continued reliance on the main credit rating agencies and the latter's "obsession" with the debt-to-GDP ratio as a measure of debt sustainability, arguing that it masked judgements about the country's "political will" (which historically had proved ill-judged) and ignored Italy's ability to pay its debts.

In the meantime, Italy was due to respond to Brussels's queries regarding its budget plans on Monday, even as another ratings agency, Standard&Poor's, was due to publish its own ratings review on Friday, 26 October, with a downwards revision in the outlook to "negative" seen as possible.

That meant that come early 2019, S&P and perhaps also Fitch, might downgrade Italian government debt, to just one notch above "junk", further reducing Rome's room for manoeuvre.

On 31 August, Fitch lowered the outlook for Italy's BBB long-term debt rating (which was two notches above "junk") from "stable" to "negative".

S&P was also at BBB, with a "stable" outlook.