The Italian drama continues, with the European bond markets demonstrating great resilience despite the risks presented by the Italian government’s proposed fiscal policy stance, which has been rejected by the European Commission (EC). Earlier, after receiving Italy’s draft budget, the EC had asked Italy to explain why the government decided not to comply with European Union rules and the agreed government deficit targets for the years 2019–2021. The Draft Budgetary Plan calls for increasing the deficit to 2.4% of GDP in 2019 from 1.8% this year. Italy responded that it is unwilling to modify its draft budget. This stance led the EC, in an unprecedented move, to formally reject the Italian budget and request the government to submit within three weeks a revised budget that complies with European Union fiscal rules.

The EC will then have to decide what to do about Italy’s response (or lack of response) by the end of November. If Italy fails to take decisive steps to bring its budget within or at least closer to EU rules, the EC could begin the process leading to the opening of an Excessive Deficit Procedure, which could result in significant fines. The scene is set for an extended period of tension between the Italian government and Brussels. Italy appears determined to stick to its budget plan as long as market pressures remain within tolerable limits, which has been the case thus far. Resisting EC demands is popular domestically, but the Italian government appears to be keeping a lid on rhetoric in an effort not to stoke market concerns. The EC similarly wishes to avoid increasing tensions, with the economic commissioner, Pierre Moscovici, stressing that he wishes to “maintain a constructive dialogue” with Italy.

Italian financial markets obtained some relief through credit rating agency actions in October. First, on October 19, Moody’s downgraded Italy’s sovereign debt to Baa3 with a stable rating outlook, the lowest investment-grade rating. A week later Standard and Poor’s left Italy’s rating at BBB, two notches above its sub-investment (junk) category, and lowering its outlook to negative from stable. The market’s relief was due to concerns that the ratings decisions could well have been worse. Maintenance of investment-grade ratings is important for portfolio managers. The 10-year Italian government bond yield eased to 3.33% Monday, October 29, a one-week low; and the spread over the equivalent German Bund eased to 299 basis points. The next day the rally reversed and the 10-year rate rose back to 3.45%. On October 19, the spread had reached 333 basis points, the highest since April 2013. The deputy prime minister has suggested that it would take a spread of at least 400 basis points for the government to rethink the budget.