Line chart of the 10-year Italian yield spread over Germany, showing% points The additional yield required for Italian debt vis-à-vis Germany has shrunk

Italy’s bond rally is forcing key risk to its lowest level since 2018

A rally in Italian debt has brought the perceived risk of holding it to its lowest level in two and a half years as investors look to further bond purchases from the European Central Bank.

Investors see the gap between Italy’s borrowing costs and those for super-safe German debt as a barometer of political tension both in Italy and across the euro area.

Last week, the additional return required by investors to hold 10-year Italian bonds instead of their German equivalents shrank to less than 1.2 percentage points – the narrowest since April 2018.

The most recent catalyst came from ECB chief Christine Lagarde, who in a speech on Wednesday dropped a strong hint that the ECB is preparing to increase its bond purchases and cheap loans to banks over the next month to keep borrowing costs under control hold. It is the task of monetary policy to “ensure cheap financing for the entire economy: for both the private and the public sector”.

The sprawl, which skyrocketed after the general election in Italy in March 2018, paved the way for a populist coalition that clashed repeatedly with Brussels over EU budget rules. That government collapsed the following year.

The risk measure rose again in March of this year as the economic impact of the Covid-19 pandemic hit Rome’s public finances, raising doubts about the sustainability of its enormous national debt. Ms. Lagarde added fuel to the sell-off when she said the ECB was not there to “close spreads”.

Later that month, the central bank repaired the damage by announcing a EUR 750 billion bond purchase program, which was increased to EUR 1.35 billion in June. The ECB is widely expected to expand further next month to bolster an economy grappling with a second wave of the Covid-19 pandemic.

Italian spreads have narrowed further in recent weeks, even more after the apparent vaccine breakthrough last week weighed on demand for German Bunds.

“It’s” heads that I win, tails that one loses “for peripheral bonds,” said Rabobank strategist Richard McGuire, referring to the riskier borrowers in the euro area. “A second wave of the virus has supported Italy because it implies extra stimulus from the ECB, but a vaccine has also helped because it does less harm to the economy.”