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Draghi fever may drive Italian risk premium to post-crisis low

FILE PHOTO: Prime Minister designate Draghi and his new government are sworn-in, in Rome

MILAN/AMSTERDAM(Reuters) – Italy’s new Prime Minister Mario Draghi may boost the appeal of his government’s bonds for foreign investors, and could even push their risk premium over German debt to the lowest level since the euro zone debt crisis.

Known as ‘Super Mario’ in his time as head of the European Central Bank, Draghi is widely expected to re-write Italy’s plans for how to spend more than 200 billion euros ($240 billion) of EU funds and overhaul the public administration to guarantee it is well spent.

His arrival has already boosted confidence in the debt-ridden economy. The gap between Italian and German 10-year yields – the risk premium, or extra interest that Italy must offer to lure investors – briefly narrowed to 86 basis points, the tightest since 2015.

That was a relief for the Treasury, as Italy’s outstanding public debt is expected to remain above 150% of gross domestic product in the coming years – much higher than the euro zone average of around 100% of GDP.

Many are hoping that Draghi can provide some political stability and spur the ever-sluggish Italian economy into growth.

“Fading political risk and positive expectations about the economy have been boosting Italian government bonds as Draghi is well trusted at an international level and is expected to improve Italy’s prospects of an effective use of EU funds,” said Mauro Valle, head of fixed income at Generali Investments.

Valle recently upped his holdings of Italy’s government bonds, or BTPs.

While the premium has since widened as investors bet on a revival in inflation, Italian bonds have still outperformed Germany and France as well as peripheral peer Spain.

ING, UniCredit and Societe Generale all see room for the premium to rally to below 80 bps, the lowest since 2010, according to Refinitiv.

Those less bullish still expect it to hover near post-crisis lows, in an overall endorsement of Italy’s new policy path and the greater credibility and stability it gives the euro.

Graphic: Italy-Germany spread since the financial crisis – https://fingfx.thomsonreuters.com/gfx/mkt/jznvnolwxpl/italy%20historical%20spread.png

Foreign investors could play a key role in driving that rally, which a Milan-based trader who asked not to be identified said had so far mostly been driven by domestic investors.

“There’s a bit of pent-up demand from foreign investors to be able to chase this rally,” said Nick Sanders, portfolio manager at AllianceBernstein, who started targeting 75 bps once Draghi was officially appointed.

Societe Generale estimates that after selling 60 billion euros of BTPs last spring, foreign investors may have bought back between 32 and 47 billion euros, implying they could buy back billions of euros more of BTPs.

Some also say a credit rating upgrade may be on the cards for Italy, which would boost the investment case for those who face ratings constraints in their portfolios.

Citi expects sustained economic reforms could lead Moody’s and Fitch, both of which rate Italian debt one notch above junk, to bump their ratings up a notch in late 2021.

Moody’s expects Draghi’s government to invest European Union funds in high-quality infrastructure projects, which should enhance growth. It is also looking for structural reforms in government administration, the judiciary and the tax system that will help Italy absorb EU funds more efficiently.

In a bullish forecast, Morgan Stanley sees scope for the premium to shrink to 55 bps in the second half of 2021, the lowest since 2008.

Delivery and then growth will be crucial, however.

“To go further in terms of tightening, the market needs to see results, mainly in terms of economic growth,” Generali’s Valle said.

($1 = 0.8280 euros)

(Reporting by Stefano Rebaudo in Milan and Yoruk Bahceli in Amsterdam; Additional reporting by Sara Rossi in Milan; editing by Thyagaraju Adinarayan and Hugh Lawson)

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