10-year sovereign local bond yields in Italy fell to a low of 2.70% in the first half of January, matching our model fair value estimates, after fluctuating in the 2.7-3.7% range in the second half of 2018. The deal with the European Commission (a reduction of the planned 2019 budget deficit from 2.4% to 2%) in December 2018 reduced the perceived political risk, readjusting bond yields towards the current fair value.
Going forward, our model sees 10Y yields fair value to average 3.1% in 2019, before increasing to a 3.3% average in 2020. This increase in fair value is driven mainly by our assumptions of a GDP slowdown (we currently expect 0.7% in 2019E and 0.8% in 2020E), together with the end of the ECB QE in December 2018. Should the country fall into recession and no QE happens, our estimates would move up to 3.4% in 2019E and 3.6% in 2020E.
The total funding needs of the Republic are estimated by the Treasury at EUR 251bn this year, slightly above the EUR 234bn in 2018. Overall, we do not see this amount as particularly alarming, as it is well within the historical range and it will continue to benefit from the ECB’s influence via the reinvestment of the QE portfolio. Bouts of risk aversion are likely to be repeated, especially given that the next budget season is likely to be as challenging as the one that has just passed. That said, the government is well placed to control the budget execution, even if the economy falls into recession and the poor Eurozone growth outlook keeps the ECB on Italy’s side for many more years.