Investors look to ECB for further stimulus after Italy downgrade

A surprise downgrade of Italy’s credit rating has raised the pressure on the European Central Bank to beef up its bond-buying programme, according to investors.

Fitch cut its Italian rating to a single notch above “junk” late on Tuesday, saying that the rise in the country’s debt levels due to the coronavirus crisis would increase doubts over the sustainability of Rome’s finances.

But fund managers and analysts said the muted market reaction on Wednesday was a sign of confidence in the ECB’s ability to contain a rise in borrowing costs across the eurozone, ahead of its policy meeting on Thursday.

Italy’s bonds weakened slightly on the day, pushing the country’s 10-year yield up to 1.75 per cent, but well below last week’s one-month high of more than 2.2 per cent.

Dickie Hodges, a portfolio manager at Nomura Asset Management, said he bought Italian 30-year bonds following the downgrade, betting that it would provoke promises of more intervention from ECB president Christine Lagarde.

“There’s no turning back for the ECB,” said Mr Hodges. “Every time the market starts to lose confidence in Italy, they will have to step things up. It doesn’t really matter whether Italy goes subinvestment grade if the central bank is buying everything.”

Fitch’s move was unexpected, coming three months ahead of its next scheduled review of Italy’s rating. The New York-based company said the severity of the viral outbreak and the scale of Rome’s response, which is expected to push debt up to 156 per cent of gross domestic product, had forced its hand.

“We are obliged to deviate from the calendar in order to comply with our legal obligations to update our credit ratings on a timely basis, reflecting situations where there is a material change in the creditworthiness of the issuer,” it said.

Fitch said it assigned a “stable” outlook to the rating, citing the support of the ECB in keeping down borrowing costs. However, low bond yields “partly reflect low nominal GDP growth prospects and do not provide unlimited support to sovereign ratings”.

Italy’s credit rating has proved to be a highly sensitive topic in the past. In 2014, Italy’s state auditor said Standard & Poor’s had failed to consider the country’s rich cultural history as it alleged that agencies had acted illegally in downgrading its rating.

Investors also drew comfort from S&P’s decision not to downgrade Italy on Friday, holding its rating two notches above junk status. Rival agency Moody’s, which rates Italy a single notch inside investment-grade territory, said on Friday that Rome’s creditworthiness should not be affected by the pandemic. If two of the big three agencies were to cut Italy to junk, its bonds would be ejected from major indices, forcing some investors to sell.

“We are a step closer to that ultimate cliff edge,” said Paul Brain, head of fixed income at Newton Investment Management. “But now that all three agencies have had their say, I don’t think they’ll be changing their minds tomorrow. There’s a window of three to six months where Italy is safe.”

Attention now shifts to Thursday’s ECB meeting. While most economists expect the central bank to increase the scale both of its asset purchases and its cheap funding of the banking sector in coming months, some believe it may decide against announcing any fresh measures this week.

“I’m just not sure that the market and political pressure is high enough for them to do something yet,” said Frederik Ducrozet, strategist at Pictet Wealth Management. 

Analysts note that EU leaders are still discussing proposals to create a recovery fund for the region’s coronavirus-stricken economies — a move that would relieve some of the pressure on the ECB in its efforts to prevent the pandemic spiralling into a financial crisis.

Even so, investors are looking for hints from Ms Lagarde that further action is in the pipeline.

“There will be disappointment unless there’s a strong signal that they are prepared to do more,” said David Riley, chief investment strategist at BlueBay Asset Management.