We expect the BTP vs. Bund spread to widen back to 250bsp area in the coming 36 months. This is because: 1. The recent tightening of BTPs vs. Bunds has been driven partly by the easing squeeze in German bonds. We think that this factor will now start fading as it has been already priced in, and that the Italy-Germany spread will be mainly driven by factors related to Italy and the general risk sentiment that we expect to turn worse again. 2. Italian debt fundamentals have weakened. Recent calculations by Bloomberg Economics concluded that Italy’s debt/GDP ratio is set to rise to nearly 190% of GDP by 2040 from 150% at present given the current yield curve. This is a dramatic change from January when similar calculations indicated the debt/GDP ratio declining gradually in the coming decades. We think that the question of the Italian debt sustainability, or lack thereof, will gain market focus in the coming months. 3. Upcoming TLTRO repayments are expected to trigger selling pressure in Italian bonds as banks are closing carry positions when they repay TLTRO loans to the ECB. The first voluntary early repayment after the change in TLTRO conditions will take place on 23 November (read details here). We recommend building the position in several stages, starting at current spread levels. - Sell IKZ2 vs. buy RXZ2 - Risk neutral amounts: 120x IKZ2 vs 100x RXZ2 - Spot spread based on CTD (cheapest to deliver) bonds: 210bps - Target: 250bps
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