Moody’s cut Italy’s credit rank by one step to Baa3, its lowest investment-grade rating, on concern the government’s budget will erode its fiscal strength and stall plans for structural reform. But its decision to set the outlook for the assessment at “stable” may be enough to reassure investors after a selloff pushed yields on the nation’s 10-year bonds to the highest since 2014.

“This was the softest move possible and should be a relief for investors,” Ciaran O’Hagan, the head of euro-area rates strategy at Societe Generale, said in emailed comments. He recommended investors buy Italian government bonds after the decision. “Uncertainty has been removed. This deserves to be rewarded with a good rally.”

Italy’s financial markets have been under pressure since the coalition government pushed for a higher-than-expected deficit in its budget, damaging investor confidence in its ability to reduce its 2.3 trillion-euro ($2.7 trillion) debt load and setting it on a collision course with European authorities. It also raised concern ratings firms would cut the nation below investment grade, triggering forced selling of government bonds.

While it leaves Italy with its lowest credit rating since the euro was formed, the downgrade fell short of investors’ worst expectations, paving the way for a relief rally. The 10-year yield touched 3.81 percent on Friday, a level last seen in 2014 when the nation was still recovering from Europe’s sovereign debt crisis. And while the securities did stage a late-day bounce to close at 3.48 percent, that’s still more than double this year’s lows and represents a premium of more than 300 basis points over benchmark German bunds.

By some measures, Italian bonds had already been trading in line with junk-rated nations.

SocGen wasn’t alone in expecting Moody’s to stick at a “stable” outlook. A one-step downgrade may see the 10-year yield spread narrow toward 250 basis points, Banco Bilbao Vizcaya Argentaria SA saidbefore the decision. Strategists at Citigroup Inc. saidthe yield gap would drop below 300 basis points in their base-case scenario of a one-notch downgrade and the removal of the negative outlook.

S&P Global Ratings, which rates Italy two notches above junk, is due to review the country on Oct. 26. Having upgraded Italy this time last year, that company “is not going to want to yoyo around,” SocGen’s O’Hagan wrote. Once its decision is out of the way, it will “eliminate one more uncertainty in the lead-up to year-end,” and that will translate into higher prices for Italian government bonds, he said.

Still, there are plenty of question marks hanging over Italy. Its swollen debt relative to its gross domestic product gives the government little financial wiggle room, while it remains under pressure due to internal disputes within the volatile coalition at home and European Union criticism of the budget.

The country’s biggest newspapers have already been running front-page stories about the bond spread as investors balk at the budget targets unveiled by the populist government. It may take further reassurances before “lo spread” — which entered Italian vernacular when the country was struggling to survive the European debt crisis — moves back out of the spotlight.

The prospect of turmoil within the ruling coalition is likely to become the dominant theme for bond investors from now on, according to Raffaele Bertoni, head of debt-capital markets at Gulf Investment Corp. in Kuwait City.

There’s a continued “risk of tension within the coalition over the budget,” Bertoni said in a Bloomberg TV interview. “Going forward, the market will focus more on the internal issues of the Italian government rather than the rating.”

The spread will tighten no more than 20 basis points on Monday, Bertoni added.

The continent’s politicians are gearing up for an epic campaign that may determine whether six decades of integration can survive a resurgence of nationalism.

Still, the voters who will decide are yet to really tune in, with a third saying they most likely won’t participate, according to the Eurobarometer survey published this week.

European voters have traditionally paid far more attention to their national elections than ballots for an EU legislature that still feels distant for many.

People really care about immigration, the key issue for nationalists like Italy’s Matteo Salvini and Viktor Orban of Hungary. The plan for more integration that French President Emmanuel Macron is pushing fails to stir passions in the same way.

It may be the U.K. that’s due to leave before the election, but Italians are even less enthusiastic about EU membership.

But most people aren’t even of when this election is due to take place anyway. (It’s May 23-26.)

The yield on Italy’s 10-year surged as much as 15 basis points to around 3.70 percent on an intraday basis, widening the spread over equivalent German debt to levels unseen since 2013, while Europe’s common currency slid as much as 0.4 percent to $1.1455. Italy’s Draft Budgetary Plan for 2019 constitutes “an obvious significant deviation” from European Union rules, Commissioners Valdis Dombrovskis and Pierre Moscovici wrote in a letterto the country’s finance minister that was released publicly after the local bond market closed.

The missive from the EU marks the start of a process, which could culminate in a decision by the European Commission to issue a negative opinion next week — essentially rejecting Italy’s budget — and asking the Italian government to send it back with revisions. That has never happened before.

“The Italian government is going to get further into this standoff with the EU,” said Ben Emons, chief economist at Intellectus Partners LLC. “The market is continuing to realize that there is not going to be an easy resolve and there will be a lot of brinkmanship as we are seeing.”

Italian Finance Minister Giovanni Tria said the EU and Italy have different views about the country’s policies and he hoped “with dialogue” these views would “come closer together.” Moscovici said the letter is not final and there is still time which should be “used productively” to continue to exchange views.

European Central Bank president Mario Draghi for his part told EU leaders at a summit in Brussels Thursday that questioning the bloc’s rules can worsen financial conditions and damage growth, according to an official familiar with his remarks, which are likely aimed at Italy’s budget dispute with the Commission.

For story on EU’s comments on Italian budget, click here.

The country also faces credit-rating decisions from S&P Global Ratings and Moody’s Investors Service before the end of the month, with both companies ranking Italy just two notches above junk.

The market moves came in the wake of an bond exchange operation by the Italian Treasury, which saw the government switch 3.8 billion euros ($4.38 billion) of inflation-linked securities, known as BTP Italia, for five nominal bonds with maturities ranging from 2025 to 2046. That was more than the 3 billion-euro outlined by the Treasury beforehand, but bond investors soon took umbrage, pushing the yield spread over Germany to the highest level in more than five years.

‘Despondent Mood’

“The Treasury released much more duration in the market, which is going to weigh on BTPs as whole,” said Antoine Bouvet, a strategist at Mizuho International Plc. “This confirms the despondent mood in BTP markets.”

Italy’s bonds have been roiled in recent months by the prospect that its new government’s spending plans would fall foul of EU rules and add to its already hefty stock of debt — around 130 percent of gross domestic product. The Treasury likely wanted to take advantage of a slim window of opportunity before headlines continue to bruise Italy’s ailing debt market, according to Societe Generale SA.

“They need to raise cash so finding a quiet time to do that is important,” said Ciaran O’Hagan, head of European rates strategy. The Italian Treasury “needs to refinance maturing debt by issuing new bonds and that process is almost continuous given that Italy is Europe’s largest issuer.”

Italy bought back the BTP Italia maturing in April 2020 and sold bonds maturing in 2025, 2028, 2029 and 2046 through a syndication of banks. Italy’s 10-year yields climbed 11 basis points to 3.66 percent, with the spread over Germany hitting 326 basis points, the highest level since April 2013. The bonds of Spain and Portugal also dropped, with the former having to digest its own wave of supply, while yield on U.S. Treasuries fell amid a bid for safer assets.

• Italy set next year’s budget deficit at 2.4% of GDP. That would be unchanged from the shortfall registered for 2017, though it exceeds most of the figures leaked to the media.
• Additional deficit projections for 2020 and 2021 should be released later today along with the GDP forecasts that underpin the estimates. All of those will be important to watch.

The figure announced last night in itself won’t wreak havoc on the country’s huge stock of debt. With a shortfall of 2.4% of GDP, the debt-to-GDP ratio should still fall slightly in 2018 to about 130.4% from 131.2%, according to our calculations.

Budget Deficit Fails to Narrow

The real problem for the Italian government is Brussels. An EU official told Bloomberg News that the headline deficit should have been around 1.6% to ensure a marginal improvement in the structural balance — that’s the cyclically adjusted balance excluding one-time items, such as bank bailouts. The IMF previously estimated the structural deficit would be about 1.3% for 2018.

It was only in negative territory because of the huge burden created by debt servicing costs. The primary balance, which excludes interest payments on government debt, should stand at about 1.9% at the end of this year. With the economy growing and inflation perking up, that’s still high enough to chip away at Italy’s huge stock of debt. However, the European Commission would like Italy to pay off the debt at a faster pace next year.

The next step for Italy will be to present the budget to the EC by Oct. 15. EU officials already have grounds to start an excessive deficit procedure. Under EC rules, if the debt-to-GDP ratio surpasses 60%, the overshoot must be reduced by 5% annually. (For example, if the ratio stands at 80%, it must fall by 1 percentage point each year.)

But launching an EDP is far from automatic. The EC examines each country’s fiscal situation and reports to the European Council on whether an EDP should be opened. The Council makes the final decision. Leniency can be shown for a whole slew of reasons.

As the EU official alluded to, the EC is unlikely to be overly lenient in the absence of any improvement in the structural balance. As part of the “preventive arm” of the EC’s fiscal rules, the structural budget deficit may not surpass a medium-term objective of no more than 0.5% of GDP if the debt-to-GDP ratio is above 60%. A compromise between Brussels and Rome will have to be found.

In the meantime, financial markets may do some of the EC’s work for it by applying pressure on Italian government bonds. The 10-year sovereign yield has risen 30 basis points today to 3.18%. Because the average maturity of Italy’s debt is seven years, the seven-year yield provides the best read on the damage that will eventually be done to the country’s finances. It now stands at 2.77%. A sustained rise of that figure above 3% would make the stock of debt too expensive to finance.

Seven-Year Yield Jumps

The coalition government has yet to release all the details of its budget projections – more bad news may lie ahead. It’s not just next year’s deficit that matters. The figures for 2020 and 2021 will also be in sharp focus. If the deficit exceeds 3% in either of these years, which may well be the case if the government’s spending plans are phased in over time, Italy’s sovereign yields would probably rise significantly — it would also cause major ructions with the EC.

Looking at the GDP projections used to calculate the deficits will be important as well. We forecast GDP growth of 1.1% in 2019 and 2020, slowing to 1% in 2021. The IMF expects 1.1%, 0.9% and 0.8%, respectively. The EC forecasts 1.1% in 2019. Any projections from the Italian government significantly above those rates would cast doubt on the credibility of the budget forecasts.

“At the moment we see good value in Greek covered bonds, which we’ve been invested in since October last year,” Henrik Stille, portfolio manager, said in an interview on Monday. “We still see some value there.”

Greece turned a page on the sovereign debt crisis that exploded eight years ago, exiting a bailout on Aug. 20. Earlier in the month, Fitch Ratings upgraded the country one step to BB- citing improved “general government debt sustainability” and noting that confidence in the banking sector is rising.

Nordea’s Danish fixed income and European covered bond team manages about 39 billion euros ($45 billion). Its European Covered Bond fund has returned 4.3 percent a year on average over the past five years, beating 90 percent of its peers, according to data compiled by Bloomberg.

It holds about 100 bonds including debt issued by National Bank Greece SA. Stille says it’s also still possible to find some “attractive opportunities” in Denmark and Sweden, as the Scandinavian markets aren’t trading as tight as their European counterparts.

“From time to time, we also see value in Denmark and Sweden,” he said. “But it’s not the overall market that is attractive. It’s more specific segments of these markets we like.”

Active Strategy

The fund doesn’t take any duration bets but has an active strategy based on relative value.

“The relative value between the markets can vary quite a lot in a year,” he said. “Especially between the markets in euro and the markets in the domestic Scandinavian currencies. It’s important to be active and move the exposure around.”

Tapering by the European Central Bank won’t have a big impact on covered bond spreads as the bank will keep reinvesting, Stille said.

“Many of the core European countries — like Germany, France, Netherlands and Scandinavia — there we think covered bonds are rather attractive versus government for example,” he said. “Even though spreads are a bit tight in absolute terms we don’t think that they are too expensive.”

Nordea’s low duration European covered bond strategy, which has a duration of one year compared with five years for the European Covered Bond fund, has experienced big inflows, passing 1 billion euros in assets after being launched in October last year.

“Investors don’t think that they’re getting compensated enough for taking risk in the financial markets at the moment,” he said. “It’s better to buy covered bonds that are the safest bonds you can invest in, because then you get an investment that is much safer if we run into financial turmoil.”