Our Global Head of Forex Strategy, Peter Kinsella, discusses how Italian bond yield increases are going to affect the euro.

This week the Eurogroup will meet to try to find a solution to financing COVID-19-related health and income support measures for the most badly affected EU nations. Italy, in particular, has forcefully argued for the costs to be borne by the whole of the EU. This has, however, been rejected by northern European countries, who fear that it will lead to a mutualisation of eurozone debt. We anticipate that the Eurogroup will either increase the European Stability Mechanism’s (ESM) borrowing capacity or seek to leverage the European Commission’s future budget revenues. These measures may bring some relief to markets in the short term, however, when the crisis passes, Italy could easily run a debt-to-GDP profile of around 160%.

Consequently, we believe that recent Italian yield increases will be sustained over the medium term, because investors will demand higher risk premia for holding Italian debt. The ECB has allocated around 40% of its recent asset purchases to Italian debt, which is far in excess of the Italian share of the ECB’s capital key. In the absence of ECB purchases, Italian yields would be substantially higher.

When the global recovery emerges in the third quarter, we believe that investors will pay closer attention to eurozone yield developments and this may present material risks for EUR exchange rates.

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Peter Kinsella
Global Head of Forex Strategy