Italian fiscal policy could see more hawkish ECB

Italian expansionary fiscal policy is more likely to inform European Central Bank policy than political threats to financial stability, with some investors raising concerns the central bank could soon switch to a more hawkish tone.

ECB

The ECB governing council meets on Thursday 14 June. While no decisions are expected on interest rates, markets will be watching for commentary surrounding the gradual withdrawal of quantitative easing. The current monthly pace of €30bn net asset purchases are intended to run until the end of September.

In the week preceding the meeting, governing council member Peter Praet indicated that the central bank was pleased with the rise in inflation in the eurozone and suggested the central bank would be mulling a gradual unwinding of net purchases, based on underlying strength in the economy and pass-through to wage and price formations.

Eurozone inflation was 1.9% in May up from 1.2% in April, while GDP growth was 0.4% in Q1, according to Eurostat.

Chris Godding, chief investment officer at Tilney, says there is still a risk that the ECB could change to a more hawkish tone fairly quickly.

Godding argues that the current policy is “only where it is to support Italy”. “It is inappropriate for Northern Europe and the fiscal impulse in Italy should alter the thinking at the ECB.”

“The ECB certainly has form when it comes to gradualism and the data so far this year suggests that there is no rush to tighten.  However, they will need to recalculate their policies if Italy ignores the fiscal rules and injects significant additional stimulus,” he says.

Likewise, Architas’ investment director Adrian Lowcock also believes that Italy’s political crisis will have some impact. “It will no doubt be a factor, but I don’t think it would be a deciding one – after all that would send a very powerful message to the populists in Italy.”

Lowcock views political risk as a feature of the EU and common place in Italy.

Forward guidance

However, Darius McDermott, managing director at Chelsea Financial Services, says there is no evidence yet that what is happening in Italy will change the ECB’s plans. Praet’s  comments are just a bit of forward guidance to manage expectations, McDermott says.

“It already owns about 14% of Italian sovereign bonds and will probably remain a steady buyer. I don’t think we will see rate rises in Europe because of the Italian situation.”

McDermott says his personal view is that Italy is unlikely to leave the EU.

He adds: “All the data I have seen points to the fact that most Italians feel more European than we do in the UK, so even if they had a referendum (at the moment it isn’t allowed in the constitution), I think the result is unlikely to be ‘leave’.”

Meanwhile, Stefan Isaacs, deputy head of retail fixed interest at M&G Investments, believes that the ECB will take a gradual approach but will be unlikely to have “sufficient firepower” to feel confident that they can stimulate the eurozone economy before the end of the economic cycle.

At a press event on Wednesday, Isaacs added: “Further rate cuts from here will probably do more harm than good.”

Radically different

Juan Valenzuela, co-manager of the Kames Strategic Bond Fund, says the Italian situation is radically different from the turmoil that the euro area suffered in during the debt crisis between 2010 and 2012.

Valenzuela says: “The ECB is unlikely to react to an increase in risk premium derived from fiscal prodigality that is against European laws or the unwinding of the limited structural measures approved by previous governments.

“Financial stability concerns would eventually justify a response, but we appear to be far from this point. Therefore, we still expect the ECB to be on course to conclude its monthly purchases towards the end of the year.”

McDermott says investors are still likely to see further volatility in Italian government bonds.

However, he adds that unless investors have a strong view on direction of travel, the volatility will act as an opportunity “to make small top ups to your European bond holdings.”

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