Italian bonds traded significantly higher earlier in the week as the Italian coalition government pledged to meet a lower budget deficit target in 2019. Despite the debate over whether or not this actually represented financial discipline or a series of one-time revenue windfalls, the market reacted positively. The expectation of further easing by the ECB, hopes of which accelerated this week with the coronation of Christine Lagarde as the next ECB president, also fueled the move lower in yields. Apparently, the ECB owns fewer Italian bonds as a % of the total than it does with other European countries’ outstanding debt. So, on a relative basis, Italian bonds are seen as a likely disproportionate target of further ECB bond buying. As of this writing, the Italian 2-year bond trades at a -.06% yield and the 10-year Italian bond trades at a 1.58% yield.

Why should we care about Italian bonds? First, because Italy has a lot of debt — with roughly $2.5 trillion of government bonds outstanding, almost 125% of GDP. Secondly, because the Italian economy is not doing very well – over the last year, Italy has technically been in a recession. From our perspective, this is more evidence that Europe is really suffering a significant slowdown. Finally, because negative yields around the world tends to produce significant downward pressure on US yields as capital flows into more attractive US bonds.

We believe this is creating quite a dilemma for the Fed, largely forcing them to cut rates in the near term even as US economic data – when looked at through a traditional lens — does not suggest this is warranted. Despite the Fed’s efforts to narrow policy decisions to US-centric data (except in times of crisis), global politics and progressive central banks are making it difficult to ignore the contagion risk that is increasingly washing up on US shores.

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