GLOBAL CREDIT BULLETS | Monday, 25th July 2022

Italy – Early elections
The Italian political crisis culminated with a government change last week, as PM Draghi was not able to obtain confidence in Senate. Right-wing parties, led by Lega and Forza Italia, have removed support to the government amid disagreement on specific decrees, pre-condition to receive the next tranche of European funds. President Mattarella dissolved the Parliament and picked 25 September as the date for early elections. The current government will remain in charge until then. The next government is very likely to be right-wing.  Right wing parties total almost 50% combined in the polls, with extreme Fratelli d’Italia party leading with 24% of the preferences. Right-wing parties also have the advantage of a ready coalition, while the left will need to find a new one, especially now that PD and 5S won’t be able to join forces. With the current electoral system, however, governability will remain an issue unless a really strong majority emerges. A right-wing government is likely to be tested by the market, especially in terms of fiscal discipline and attitude towards Europe, so spreads may turn volatile into elections. The current government will try hard to secure the next PNRR tranche before the election day, but it’s unlikely to succeed, moving the burden to obtain disbursal to the next government. BTP-bund spread remained relatively well behaved last week, also thanks to ECB support, and remains 25bp below June highs. Volatility is likely set to increase into elections day and the rhetoric of the right-wing into September will be key to Italian assets.

ECB – Hikes & spreads
At its July meeting last week, the ECB surprised markets with a 50bp hike, bringing the deposit rate to 0%. Market broadly expected 25bp, in line with previous guidance. The larger-than-expected hike was likely driven by weak Euro, which flirted with parity for the past few weeks, and risked breaking especially as the Fed will hike 75bp this week. Guidance for September remained open, and MPC members comments post meeting suggests there is some disagreement regarding the continuation of hikes in larger steps. All in, we think the ECB will hike 50bp again, as global central banks stepped up pace and the third quarter may display a deeper slowdown, reducing the room to hike faster then. The ECB also presented its Transmission Protection Instrument (TPI). The instrument allows to purchase a country’s debt amid “unwarranted” market moves in such debt prices. Eligibility criteria include sound macroeconomic and fiscal policy, but are left relatively vague. No maximum amount is set. Overall, we think the instrument is quite flexible, and guidance is vague enough not to preclude large interventions on fast market moves. This feature is likely to deter extreme moves. At the same time, however, political noise regarding policy may not fit the ECB notion of “unwarranted”, so the ECB may intervene verbally to clarify this when needed. We find the instrument flexible enough to protect spreads over the coming month, but we see a clear limit imposed by the ECB. As a result, the upcoming electoral campaign poses an important risk to periphery spreads in the next few months.

Fed – Another large hike on the radar
At its Wednesday meeting, the Federal Reserve will continue to sound hawkish. The central bank will hike rates by 75 point, bringing the Fed target to 2.25-2.5%. In June, inflation made new highs and labor markets remained strong. Inflation expectations have not been increasing but remain elevated. As a result, all the signals the Fed has pointed to as relevant remains in overheating territory, and action and language will be hawkish. Household survey and leading GDP indicator are less positive, and point to some moderate slowdown in the third quarter, in line with global data. The Fed is likely not to put too much emphasis on those for the time being, and wait for signs of inflation moderation before opening to a less firm stance. There are two inflation prints before the September meeting, and our model point to considerable downside there (more in our recent Algebris Bullet – Fight Your Fears), amid easing supply restrictions. We thus think the tone in September may be radically different, finally opening for less tight policy in the subsequent months.

---

Algebris Investments’ Global Credit Team