EGBS: S&P Downgrade To AA- Seems Likely, OLOs Could Underperform OATs Ahead

Additional Italy-Germany spread narrowing may require support from domestic macroeconomic/fiscal factors.

• Fiscal: Q2 Italian fiscal data is due on October 3. Recent fiscal consolidation has culminated in the first primary surpluses (on a 4Q rolling basis to GDP) since Q1 2020. Persistent primary surpluses are a necessary condition for the debt/GDP ratio to start easing in line with Government/EC projections from 2027. Looking ahead to the fiscal trajectory beyond this year:
  • Bloomberg reported earlier this month that lower bond yields have created E13bln of extra fiscal space across 2025/26.
  • Meanwhile, the Government is still trying to find a concrete way of raising revenue from the banking sector. It recently drafted plans to raise E1.5bln from banks through postponing tax deductions. This has historically been a politically difficult issue to navigate for Meloni.
  • Furthermore, the FT reported this morning that the Government is considering a freeze in the retirement age of 67. The current retirement age is linked to life expectancy improvements, so has automatically crept higher over the past decade. Freezing the retirement age could put pressure on public finances, and worsen Italy’s existing demographic problems.
• Growth: Q2 real GDP growth was -0.1% Q/Q, and growth momentum has waned in recent quarters as the Superbonus tax credit tailwinds faded. However, analysts expect sequential growth rates to pick up in Q3 (0.1% Q/Q - flash print due October 30) and Q4 (0.2% Q/Q), which will be necessary for continued improvements in fiscal metrics as a % of GDP. That said, Italy’s weak productivity and demographic problems continue to limit potential growth rates.
• Ratings: Fitch upgraded Italy’s sovereign rating to BBB+ last week. S&P are due to provide a review on October 10th, but we don’t expect a ratings update given they already upgraded Italy to BBB+ in April. There’s more interest in Moody’s review on November 21. An upgrade from the current Baa3 rating appears likely, but we wouldn’t exclude a 2 notch upgrade to Baa1 to align with S&P and Fitch, particularly if the Q2 fiscal and Q3 flash growth data are encouraging. 

• Italian bonds have outperformed Eurozone peers through 2025, with persistent tightening to Bunds observed since early April (and on a longer-term basis, since 2022).
• The 10-year BTP/Bund spread has tightened almost 40bps year-to-date, and is currently hovering around 81bps – slightly tighter than the OAT/Bund spread.  There have been several touted drivers for the outperformance versus Bunds and other EGB peers over the past 5 months: Relative political stability in Italy compared to peers such as France, ongoing domestic fiscal consolidation and associated positive ratings action, a pullback in EUR rates vol and finally expectations for higher German fiscal spending.
• From a technical standpoint, the trend remains in favour of further tightening. However, the spread has struggled to meaningfully push below the 2010 lows of around 76bps in recent weeks.

The 'inter-union', formed of France's major employee unions/confederations, is set to engage in another day of strikes and protests against the gov't of PM Sebastien Lecornu. The French Democratic Confederation of Labour (CFDT), one of the five major trade union confederations, announced the planned industrial action to take place on 2 October. This follows meetings earlier today between union officials and Lecornu at Matignon. 

• Ahead of today's meeting, Liberation outlined the inter-union's demands from Lecornu: "Abandonment of the increase in the retirement age to 64 , the doubling of medical deductibles, the freezing of benefits, a new reform of unemployment insurance, but also "social and environmental conditionality of public aid to private companies" ... The list of union demands is long and the suspension - at a minimum - of the 2023 pension reform occupies a central place."
• Lecornu meets with employers' organisations this afternoon, as "The head of the Medef (French employers' association), Patrick Martin, denounced the "dangerous theories for our businesses" that fuel the debate, such as the Zucman tax."
• The 18 September strikes resulted in significant disruption for industry, schools and public transport, with some outbreaks of violence reported.
• The gov't remains in an extremely vulnerable position, unable to pass an austerity budget that former PM Francois Bayrou argued was crucial for restoring the public finances, and short of a majority in the National Assembly. A gov't spox said earlier President Emmanuel Macron did not discuss the option of dissolving parliament during an earlier meeting with the Council of Ministers.