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Worst Month Ever in Italian Bonds Leaves Confidence in Tatters

Anooja Debnath, Cecile Gutscher
A cyclist crosses Piazza de'Frescobaldi in Florence, Italy, on Wednesday, July 6, 2016. Maintaining inherited wealth has worked for generations of the Frescobaldi family over 700 years, and it has let the descendants of Jakob Fugger in Germany continue to run the Fuggerei social-housing complex the Emperor's banker founded almost half a millennium ago.

Italian bonds may have bounced off this week’s stunning losses, but some of the biggest investors say the worst isn’t over.

While the nation’s benchmark yields had biggest monthly jump in May since records began in 1993, they are “still pretty low” for Andrew Balls, chief investment officer for global fixed income at Pacific Investment Management Co. The firm has had an underweight position on Italy’s debt, he said, as political and market uncertainties persist.

“Anyone who’s got a clear idea on Italy over the next couple of years are a lot smarter than we are,” Balls said in a Bloomberg Television interview. “I haven’t got more gray hair over the weekend because in times of great uncertainty you can just try and watch from the sidelines.”

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The political upheaval in Rome that brought the euro’s very existence into question saw the spreads between Italian and German bond yields to surge beyond 300 basis points on Tuesday, the widest since 2013. It has retreated to about 250 since then.

Still, “it is too early to conclude that the worst has passed,” Martin van Vliet, a strategist at ING Groep NV said in emailed comments. Analysts including van Vliet have come up with a range of potential scenarios on the spread may move, corresponding to how the Italian risks evolve, over the next six to 12 months, according to an ING note to clients published this week.

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  • The “most benign” outcome could contain the yield gap in the upper half of a 100-200 basis point range, while a “muddling through scenario” that seems most likely may see it settle in the 200-300 basis point band, they predict
  • But things could get a lot worse. An “escalation” of the situation could lead to a sovereign downgrade for Italy and see foreign investors cut their holdings of the nation’s bonds. In such a case, the yield differential will probably shoot up to 500 basis points, according to ING
  • The low-probability, worst-case scenario where “markets increasingly discount an Italian exit from the euro zone” could send the spread as high as 1000 basis points

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