• Barclays expects Italy’s debt crisis will be managed to the end of the year without sparking an immediate catastrophe.
  • However, amid a tenuous domestic political alliance and looming showdown with the EU, the situation remains on a knife-edge.
  • The Barclays analysts didn’t rule out a further spike in Italian bond yields, and possible snap elections at the start of next year.

Research from Barclays shows there’ll be no easy fix for Italy’s debt crisis – one of many factors keeping global markets on edge at the moment.

There was a serious bout of volatility in Italian stocks and bonds last week, as the Italian government refused to budge on its spending plans for the 2019 fiscal year.

Barclays’ base-case is that there won’t be an immediate catastrophe, and the budget is likely to pass through Italian parliament by the end of the year.

But viewed through the lens of two key risk factors – domestic politics and the bond market – it’s clear the situation is still poised on a knife-edge.

Political risk

The European Council wants Italy to reign in spending to get debt levels under control. But based on the government's budget forecasts, there's no chance of that happening. In fact, it's only getting worse.

As a result, "we expect tensions between Italy and the EC to mount in the coming weeks," Barclays said.

Analyst Fabio Fois doesn't rule out the EC rejecting Italy's budget in part or in full, and requesting changes to bring the budget in line with EU spending limits.

However, he said the EC is likely to give Italy time to respond to any amendment requests, and it will postpone taking further action until the northern Spring (March-April) in 2019.

But there's another problem: Italy's ruling coalition - the centre-right Lega and and anti-establishment Five Star Movement - only holds power by a razor-thin majority.

There's a chance the new budget may not pass the Senate if the debt crisis starts to wear thin with voters, particularly supports of Lega which has been polling better in recent months.

So amid an extremely complex political picture, Barclays raised the prospect of snap elections as soon as Q1 next year if the situation continues to deteriorate.

Bond spreads

One factor which could accelerate that deterioration is Italy's bond market. Currently, the spread between Italian and German bond yields is around 300-350 basis points.

And Barclays says that's a manageable situation - for now.

"However, the risk of Italy sliding into an unstable debt spiral has increased. This could be caused by a big clash with the EC in the coming months, leading to a snap election scenario in early 2019."

While it's not the bank's base-case scenario, such an event could push Italian-German bond spreads above 400 basis points and put further pressure on the domestic banking system.

Barclay's also said there's a material risk that global credit ratings agencies will downgrade Italy's government debt.

Currently, Italy is rated Baa2 (negative credit watch) by Moody's, and BBB (stable outlook) by S&P.

Both agencies are scheduled to update their ratings at the end of the month, and any downgrades "would have the potential to further impact negatively market sentiment," Barclays said.

Between the domestic political situation, a looming showdown with the EU, and nervous bond markets, Italy's debt crisis remains one of the more perilous risk-factors on the radar of global markets.