Italy's Recession Deepens as Fitch Downgrade Pressures Debt Sales

Italy's economic contraction was deeper than first anticipated, the country's statistics agency reported just days after the eurozone's third largest economy suffered a further downgrade blow amid its seemingly intractable political gridlock.

Gross domestic product shrank by 2.8 percent during the whole of 2012, the National Statistics Agency, ISTAT, said Monday in a statement published on its website. That's 0.1 percent more than its first estimate and much deeper than the 2.2 percent estimated by the European Commission in its most recent Winter Forecast. The contraction for the final three months of the year was left unchanged at -0.9 percent, ISTAT said. Late Friday, Fitch Ratings lowered Italy's sovereign debt grade one notch to BBB+ and assigned a negative outlook to the rating, indicating further cuts could come in the near term.

"The inconclusive results of the Italian parliamentary elections on February 24-25 make it unlikely that a stable new government can be formed in the next few weeks," the Fitch report said. "The increased political uncertainty and non-conducive backdrop for further structural reform measures constitute a further adverse shock to the real economy amidst the deep recession."

Fitch estimates that Italy's economy will shrink by around 1.8 percent this year, 0.8 percent more than the EC's estimate. Outgoing Prime Minister Mario Monti's last assessment pegged the contraction at -0.2 percent.

Benchmark 10 year Italian government bond yields rose by around 5 basis points Monday to trade at 4.64 percent, according to data from the trading platform Tradeweb. The three month average has been around 4.43 percent. The difference in yield, or spread, that investors demand to hold Italian government bonds instead of triple-A rated German bunds advanced 11 basis points to 318 basis points, according to Tradeweb data. Two year bond yields also rose sharply to trade 9 basis points higher at 1.84 percent.

Credit default swap prices rose around 9 basis points to change hand at 261 basis points, traders said. This means an investor would need to pay €26,100 each year for five years to insure €10m worth of Italian government bonds from default.

The price moves will complicate the Italian Treasury's attempt to raise around €9bn in four separate bond auctions scheduled for Wednesday - which fall on the same day that Germany will raise around €5bn in benchmark two year notes and the United Kingdom will tap an existing 40-year Gilt for around £1.5bn.

Italy's political stalement enters its third week this week with Parliament due to reconvene Friday with the aim of establishing an agreement to form the next government. President Giorgio Napoliatano will begin consultations with party leaders next week.

"A new government will have to pass a vote of confidence in parliament, but the real tests will come later: Italy's economy needs urgent reforms and its treasury is heavily reliant on bond markets," said RBS strategist Alberto Gallo. "In the pre-euro era, a weak coalition could buy time by devaluing its currency and limp along for a year or more. It needs to cope with a strong euro and with cracks in Italy's industrial and social structure."