Several major central banks will meet next week, including the European Central Bank, but it is only the Bank of Canada that is expected to hike rates. The flash PMIs and the first official estimate of Q3 US GDP are among the data highlights. Beyond the events and data, the volatility from global equity markets from Shanghai to New York will continue to have a strong influence on other capital markets. Also, the escalating tension between the EC and Italy over 2019 fiscal issues poses another challenge.

The bad loan burden at Italian banks, the indebtedness of the government, and what has been political paralysis makes for a poor backdrop for the current clash. The populist-nationalist government of the Five Star Movement and the League have made electoral promises that the country can ill afford. For the northern business, the League has pushed for lower taxes and a liberal tax amnesty. As champion of the poor south, the Five Star Movement wants aid package and a limited tax holiday. Both parties want to roll back the pension reform. These type of policies repel rather than attract global savings, and Italian yields have jumped as has the premium over Germany, on the one hand, and Spain on the other. 

The EC has formally requested an explanation for the budget and Italy has until October 22 to respond. It is difficult to imagine any explanation that would satisfy Brussels and hence the EC could announce that it is returning the budget proposals back to Italy for revisions. This would be unprecedented and reflects too the evolving institutional capacity of the EC.

The EC may try to turn the conflict back within Italy itself. For example, Italy’s Parliamentary BudgetOffice watchdog refused to endorse the budget because of the optimistic budget assumptions. There also seems to be a dispute within the government about the extent of the tax amnesty.

The EU’s strategic interests may be best served by recognizing the electoral results and accept changes in fiscal policy with some optimistic economic projections, but insist that the Italian government pledges remedial action next year if there is greater deterioration than it projects. This would also give the EU some leeway insist on no reversing structural changes, like unwinding pension reform.

Just before the weekend Moody’s made good on its review announced in May and became the first of the major rating agencies to reduce Italy’s rating from the equivalent of BBB. Moody’s now rates Italy Baa3 (=BBB-). It was seen as the rating agency most likely to cut Italy, but it returned to a stable outlook which eased the risk of losing its investment grade status. In the coming days, Moody’s can be expected to adjust the rating of other entities in which the government’s rating is the cap.