IS IT REALLY POSSIBLE A DOWNGRADE FOR ITALY IN OCTOBER?

Absolutely YES. Italy’s government projects that the budget deficit will rise from 2.0% in 2018 to 2.4% in 2019 before falling to 2.1% in 2020. Italian government is very optimistic on GDP growth forecasts : 1.5% for 2019 and 1.6% for 2020. Recent OECD projections put italy’s growth for 2019 at lower threshold  (1.1% ) , and the IMF in its latest w.e.o. estimates about 1.2% growth for Italy in 2019 . If the IMF and OECD projections are fair, I’m expecting a 2019 budget deficit bigger than 2.4% (perhaps in the 2.7% - 2.8% range …but I don’t know actually ). Judging by the default risk now implied in Italy’s CDS (senior 5Y USD contracts are pricing today, Oct. 16th, around 220 bps , but they were 100 bps on April 30th ) , all rating agencies are behind the curve .. Currently, the three major rating agencies put Italy two notches above the Speculative Grade . A lot of emerging markets, such as Vietnam,  have lower CDS levels than Italy but are rated HY ( BB+ or lower). Bond markets tell us the same thing . If you take a look at the graph below I have drawn by Bloomberg terminal this morning , you can see that Italy’s yield curve (blue line ) it’s closer to BB yield curve (red line) than BBB yield curve (green line) . . In the 3y-7y range italy’s government curve is practically overlapped to BB curve : the "real" rating given by the market is 3 notches below the official BBB rating from S&P . 

We have to say that rating agencies , historically, tend to move slower than markets: Rome still has time to correct its fiscal course. But S&P and Moody’s could revise their Italian ratings at the end of October, down to BBB- , although a downgrade by more than one notch is unlikely. However , if Italy does not convince markets and rating agencies that its bonds remain safe and that it would rather change course than possibly ponder a euro exit , italy may lose its investment grade status in 2019. Losing the investment grade status would hurt seriously the interest expense over its public dept (>65BN € in 2017)for these reasons :

a)     many institutional investors who buy only investment grade paper may be forced to sell their Italian bonds , with a new rise in yields..

b)     the European Central Bank (ECB) can buy only investment grade bonds under its asset purchase programme (APP). Italy might lose out on ECB reinvestments of its maturing debt there after dec. 2018. ( anyway, the ECB takes the best rating from just one of the credit agencies. )

c)     Italy’s banks would suffer from the BTP’s turbulence : the ECB could not accept Italian bonds as collateral any more, forcing banks to use more-expensive refinancing options. Higher borrowing costs would hurt economic activity and weigh on Italy’s already weak GDP growth. We cannot exclude new capital raise in 2019 for some italian banks .

Mr Salvini and Mr. Di Maio have to consider carefully all these risks. It is absolutely important Italy not losing its investment grade status because this event automatically would bring a debt crisis soon. Rome’s fiery rhetoric exacerbates the risks. If Italy oversteps the limits and triggers a spiral of capital flight, ratings downgrades and plunging economic confidence, it may eventually descend into the fear of a euro exit or make the choice to come back to prudence and pro-growth reforms. Italy certainly would need help from the European Stability Mechanism and the ECB would come with clear conditions attached : less expenses and more taxes . Is this what Matteo Salvini and Luigi Di Maio really want ?