By Sujata Rao
(Reuters) - It's been the stormiest year for Italian bond markets since the 2011 euro zone crisis, but as 2018 ends, investors who fled mid-year are returning and their worst fears -- euro exit, junk ratings and reckless spending -- have proved unfounded.
Often described as bond vigilantes for the way they impose fiscal discipline on profligate governments, debt investors punished Italy hard for proposing a draft budget deficit three times higher than it had pledged. Sovereign borrowing costs surged to five-year highs.
That creditor strike appears to have achieved its aim. Government bond yields, already down a fifth from the highs, lurched lower again this week after the conviction grew that a budget row with the European Commission would blow over without Rome incurring significant penalties.
That optimism is fed above all by Rome's decision to trim its 2019 deficit targets, after months of acrimony. With France moving this week to widen its own budget deficit, the EU is likely to accept Italy's new suggestion.
"We thought of this as an entry point," said Tim Graf, chief macro strategist at State Street Global Advisors.
"You are getting relatively good yields, and if you have greater willingness on part of the EU to accommodate more expansionary budgets, from that perspective a 3 percent euro-denominated yield for 10 years looks phenomenal."
Italian 10-year yields slipped just below that level on Thursday, while its yield premium over Germany -- effectively a measure of a euro credit's riskiness -- has snapped in more than half a percentage point from peaks.
(Graphic) Italian/German 10-year bond yield gap this year: https://tmsnrt.rs/2PARq8O
With France's deficit now possibly approaching 3.5 percent of GDP, Italy unsurprisingly wants equal treatment. Some investors also accept that Rome needs to galvanise its moribund economy.
"Italy is not doing something system-destroying, it's not like they want a 5 to 6 percent deficit. The European Commission has to accept their need for growth," said Salman Ahmed, global investment strategist at Lombard Odier Investment Managers.
Ahmed's Italy position until recently was "100 percent negative". But heading into 2019, he has changed that to neutral, betting the Italy-Germany spread peaked a while back.
Foreigners sold 69 billion euros (61.95 billion pounds) of government bonds between May and September, but after a 3 percent drop in foreign holdings in April-June, the biggest quarterly fall since 2012, selling slowed in the third quarter, the central bank said.
September outflows were 1.5 billion euros versus August's 17.4 billion euros.
(Graphic) Euro zone bond market performance in 2018: https://tmsnrt.rs/2SK0pGq
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Of course, Italy isn't out of trouble yet: a populist government remains in place, an EU penalty is still likely and with a weak economy, its 2.3 trillion-euro government debt saddles it with one of the world's worst debt ratios, 1.3 times annual output.
Debt issues will therefore certainly come back to haunt it. But this year at least, the worst fears have not materialised. Above all, says Arnaud-Guilhem Lamy, a portfolio manager at BNP Paribas Asset Management, one huge risk -- future redenomination of Italy's debt into lira -- has receded for now.
Lamy noted that gauges of euro breakup risk, which flashed bright at the height of the turmoil, have subsided, helped by a softer tone on the euro from firebrand Deputy Prime Minister Matteo Salvini.
ADVERTISEMENT"A lot is already priced in. The market is not long (on Italian debt) as it was in May, it is neutral or short, so you won't get panic selling. So there is a positive dynamic from a technical point of view," said Lamy.
He has a small underweight on Italy but likes short-dated two-year debt because "the carry is attractive and we don't expect them to leave the euro zone in this period."
Two-year Italian securities yield 0.48 percent <IT2YT=RR> versus minus 0.17 percent in Spain <ES2YT=RR>, rated two notches higher by S&P at A-.
Mark Haefele, chief investment officer of UBS Global Wealth Management, also said he had added to holdings of two-year debt.
Most big investors are keen on short-dated bonds, which are less vulnerable to euro break-up risk and the possibility of a credit rating downgrade to junk.
ADVERTISEMENTItaly has hung on to its investment-grade rating, which guarantees its place in IG-only bond indexes. Relegation to "junk" would have ejected it from these benchmarks, triggering billions of euros in forced selling.
But S&P Global and Fitch keep Italy at BBB, two notches above junk. Moody's did cut to Baa3 in October, a rung above junk, but attached a "stable" outlook, meaning investment grade status is not immediately threatened.
ECB HAND
Rome needs investors on its side. It needs to raise 400 billion euros in 2019 for debt repayments and spending. But even though the European Central Bank's bond purchases will have ended, Italy will benefit from its reinvestment programme -- BNP Paribas AM notes the ECB will buy 35 billion euros of Italian debt in 2019, not much below this year's 50 billion euros.
ADVERTISEMENTExpectation is also building of more ECB stimulus, probably via cheap multi-year loans to banks -- some of which could leak into Italian bonds.
"I take the ECB at its word that if it can see a little willingness of the Italian government to look at deficit spending and try to control it, then they (the ECB) can solve the problems in the bond market," said Bob Michele, fixed income CIO at JPMorgan Asset Management.
"I think things will work out OK," he said.
(Graphic) ITALY-ECONOMY interactive: https://tmsnrt.rs/2DSitKC
ADVERTISEMENT(Reporting by Sujata Rao; additional reporting by Dhara Ranasinghe and Saikat Chatterjee in London and Valentina Za in Milan; editing by Larry King)
