Italy's political risks cloud debt reduction hopes amid bond turmoil

By Sara Rossi and Valentina Consiglio

MILAN, Oct 15 (Reuters) - Italy's national election next year throws doubt on Rome's plans to reverse the rise in its huge public debt, analysts say, warning that the strong market appetite for Italian bonds in recent years may be coming to an end.

Italy's €3-trillion ($3.36 trillion) government bond market, one of the world's biggest, has come under renewed scrutiny amid contagion from a sharp selloff in French debt, while domestic political uncertainty mounts and the boost from European Union post-COVID recovery funds fades.

Prime Minister Giorgia Meloni has followed a largely prudent fiscal policy, but with her rightist coalition trailing the centre-left in opinion polls, she will be under pressure to open the purse strings ahead of next year's vote, analysts say.

"We expect fiscal risk premia to continue to build ahead of the election," Filippo Taddei, Senior European Economist at Goldman Sachs, told Reuters.

ITALIAN YIELD SPREAD WIDENS

Recent weakness in Italian bonds has been driven by the selloff in France, where a weakened government is trying to pass a budget and a key election looms next year, but focus is also turning to Italy's political complications.

The yield on the 10-year bonds (BTPs) of the euro zone's third-largest economy hit 4.7% this month and the yield gap with safe-haven Bunds - a market gauge of the risk premium investors demand to hold Italian debt - reached its widest in almost 18 months.

The BTP yield has risen more than 100 basis points so far this year and is set for the biggest annual jump since 2022, when an inflation surge sparked a rise in interest rates.

Swiss bank UBS has recommended that investors go short BTPs, forecasting that the Bund-BTP spread, which was as narrow as 60 basis points in January, will widen to 150 bps. It currently stands at around 105.

A short position is a bet that an asset will weaken in price.

Goldman Sachs' Taddei said Italy's debt-to-GDP ratio, which climbed to 136.7% in 2025, will remain on a rising path at least until 2028, and warned that if 10-year BTP yields remain above 4% the debt will continue to increase in future years.

Higher bond yields mean higher debt-servicing costs. Italian interest spending exceeded €100 billion last year, while average issuance costs rose to 3% in September from 2.75% a year earlier, Treasury data showed.

DEFICIT TO FALL - THEN RISE

The government has targeted the budget deficit to fall this year to 2.9% of gross domestic product, just inside the EU's 3% ceiling, only to rise back above 3% in the next two years in order to hike defence spending and tackle surging energy costs.

The picture is not all bleak, however. Growth held up better than expected in the first two quarters and the government this month hiked its full-year 2026 growth forecast to 1% from 0.6%, thanks in large measure to billions of euros of EU post-COVID funds which have lifted investments.

With EU payments under the programme due to end by December, TS Lombard global macro director Davide Oneglia said the country now needed structural reforms, not just fiscal caution.

"Meloni doesn't have a big plan for the economy," he said at a TS Lombard conference last week in London. "Not rocking the boat is not enough and her own political stability is not certain."

Ratings agency Moody's, which a year ago upgraded Italy's sovereign rating to "Baa2" from "Baa3", raised similar concerns in a new report last week.

"Slower growth, reduced fiscal discipline or weaker reform momentum would put the projected debt reduction trajectory at risk," it said.

($1 = 0.8937 euros)

(additional reporting by Dhara Ranasinghe, editing by Gavin Jones)