Graphic: Italy investors swap 'Quitaly' fears for deflation angst

By Abhinav Ramnarayan and Ritvik Carvalho

LONDON (Reuters) - Fears that Italy will leave the euro zone and trigger a lira-fueled inflation spike have disappeared altogether from market pricing, replaced instead by less dramatic worries over low inflation and growth in the euro zone's third largest economy.

With the European Union this week saying it will not penalize Italy for breaching debt rules after Rome appeared keen to avoid such sanctions, Italy's inflation-linked bond market now suggests investor fears of a euro exit have evaporated.

Italy has one of the most liquid inflation-linked bond markets in the euro zone, issuing debt linked both to euro zone and Italian inflation.

One way of hedging 'Quitaly' risk last year was to buy Italian debt linked to local inflation over euro zone inflation on the basis that a return to the lira would result in significant devaluation, and therefore high inflation, in the country.

This trade was particular popular last summer, when concerns were high that anti-euro parties would come into power and try to take the country out of the single currency bloc.

But with the current coalition government proving more placatory than had been expected, and with Deputy Prime Minister Matteo Salvini showing no signs of trying to force a general election to secure sole control for his anti-euro League party, the trade has switched around.

"The fact that Italian-inflation linked bonds aren't reacting as dramatically suggest that people think Salvini won't force an election and markets are quite sanguine about the fear of Italy leaving the euro," said Colin Harte, head of research on the multi-asset team at BNP Paribas (PA:BNPP) Asset Management.

"Of course, if the Italian government and the EU get into a major spat and people then start fretting, you could see that trade coming back in," he added.

Italy's inflation-linked debt maturing Sept 2024, pegged to euro zone inflation, had a breakeven level of 52 basis points on Friday, but a bond maturing Oct 2024 linked to Italian inflation had a breakeven level of 4 basis points.

This sort of disparity is apparent through the Italian inflation-linked curve.

Investors swap 'Quitaly' fears for deflation angst: https://tmsnrt.rs/2FU8fcT

Breakeven levels refer to the difference between the yields on inflation-linked bonds and the conventional bond of the same maturity. A high breakeven level suggests lower yields and stronger demand.

By way of comparison, the French inflation-linked bond market has no such disparity.

For example, a French March 2029 inflation-linked bond pegged to euro zone inflation had a breakeven level of 86.5 basis points while a July 2029 issue linked to French inflation had a breakeven level of 83.9 bps on Thursday.

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ECONOMIC WOE

Instead of 'Quitaly' risk, the Italian inflation-linked bond market is now reflecting that investors are downbeat on Italy's ability to generate any sort of inflation and, by extension, this reflects concern for the country's economic future.

"The breakeven levels on BTPs linked to Italian and euro zone inflation are about 40 basis points apart in the five-year part of the curve, which points to this idea that Italy is going to underperform the rest of the euro zone in terms of inflation and growth," said John Taylor, fixed income portfolio manager at AllianceBernstein.

Euro zone inflation expectations have dropped sharply this year as investors worry about flatlining economic growth and lose faith in the European Central Bank's ability to boost consumer prices to reach their target.

Italy inflation expectations well below euro zone: https://tmsnrt.rs/2FR5R6n.

Yet, worries over the Italian economy seem even more acute, with the five-year, five-year breakeven forward rate underperforming the euro zone equivalent, which is closely watched by the ECB as a key gauge of long-term inflation expectations.

"The Italian economy has slowed down sharply, is flirting with recession, and they are likely only going to meet EU fiscal targets by the skin of their teeth," said Harte of BNP Paribas Asset Management. "Given the Italian economy is so sluggish, you would expect Italian inflation to underperform."