Italian debt markets sanguine ahead of Moody’s ratings test

By Gavin Jones and Sara Rossi

ROME (Reuters) – Investors will nervously await a review of Italy’s ratings on Friday, although analysts see little risk that Moody’s (NYSE:) will relegate the country’s debt to junk status, a move that would likely jolt markets around Europe and beyond.

Moody’s rates Italy Baa3, just one notch above non-investment grade, and has had Rome on a negative outlook since August 2002. It will issue its decision some time after 10 pm local time (2100 GMT).

A downgrade would not only trigger a surge in Italy’s bond yields and sink the stock of its banks, but would also hit the debt of other peripheral euro zone countries and probably weigh on the euro, analysts say.

The closely-watched gap between the yields on Italian 10-year BTP bonds and less risky German Bunds could be expected to widen to 2.5 percentage points (250 basis points) from around 175 basis points on Friday.

Italian debt would then find itself on “a slippery slope that could spiral into greater turmoil if the market is not getting reassurance from elsewhere,” ING said in a note to clients on Tuesday.

However, the European Central Bank would still be able limit the damage by buying Italian bonds on the market.

The bank’s rules allow it to buy sovereign debt which is rated investment grade by at least one accredited agency, and S&P Global, Fitch and DBRS all still have Italy in that category.

Analysts said the dramatic impact a downgrade would have is a major reason the agency is likely to desist, despite the fact that Italy’s economic and public finance prospects are anything but rosy.

Italian gross domestic product stagnated in the third quarter from the previous three months after contracting by 0.4% between April and June, and the government’s tax-cutting 2024 budget significantly loosened its fiscal stance.

The European Commission forecast on Wednesday that Italy’s debt, proportionally the second highest in the euro zone, would rise marginally from a projected 140% of national output this year to 141% in 2025.

THREE DOWN, ONE TO GO

Nonetheless, Rome has already emerged unscathed from three other reviews in recent weeks by S&P Global, DBRS and Fitch, all of which made no change to the country’s rating or outlook.

Italian bond yields have fallen over the last month, buoyed by hopes of an end to the European Central Bank’s interest rate hikes and the benign decisions taken so far by the rating firms.

The BTP-Bund spread has narrowed by more than 30 basis points from a recent peak of 209 basis points on Oct. 9.

Moody’s, however, which last week downgraded to negative its outlook on U.S. sovereign debt, is the agency with the lowest rating on Italy and the only one whose outlook is negative.

Several banks have issued notes this week ahead of Friday’s review, and while they all highlight the dire consequences a downgrade would have, none see it as likely.

Barclays described it as a “tail risk event” and Unicredit (BIT:) said it even saw “a slight possibility” the agency would raise Italy’s outlook to neutral.

Some analysts have noted that while Italy’s growth prospects are weak they are still better than when Moody’s changed the outlook to negative 15 months ago following a government collapse and in the midst of an energy crisis.