There has been a steep sell-off in risk assets this morning as worries surrounding the Italian government deepen and investors start cutting Italian assets from their portfolios. The moves this morning are looking increasingly concerning with price action in the Italian bonds market that has not been witnessed since the Eurozone debt crisis.
“The big question is whether this is just an Italian problem or one that risks significant spillover into the rest of Europe,” says Neil Wilson, chief market analyst at Markets.com. “The one thing that has become apparent is that markets treated the election result with excessive calm and has been jolted by the populists’ success in agreeing terms.”
President Sergio Matarella‘s decision to reject Paolo Savona as finance minister may have been a significant miscalculation, according to Wilson. The move has temporarily blocked a populist government from forming, but looks also to be strengthening the position of the Lega/M5S in the long run and plays to their anti-establishment connections. It may even encourage them to push for a more radical, anti-establishment agenda in the future.
Italian bonds face pricing issues
While the crisis looks largely contained to Italy at the moment, it has scope to spread. Italian bonds are still moving according to their own agenda, while the Euro has given some ground this morning. The EUR is still mounting a firm defence at 1.15 for the time being. Italian stocks were under performing Europe this morning with the FTSE MIB down more than 3% before bargain hunters produced a slight paring of losses.
Italian bonds have seen yields rising sharply with spreads widening against Bunds. The Italian 2-year yield has jumped above 2% and has kept going, approaching the 2012 sovereign debt crisis territory at 2.4%. Spreads with 10 year Bunds are now at their widest level since 2013.
This is having a knock on effect on the bond market infrastructure. Traders in London today reported that it was proving difficult to trade Italian bonds or to even get price quotes on some parts of the bond curve. Liquidity seems to have disappeared from the Italian bond market as the crisis in Rome heats up. Italian bonds represent one of the biggest and most liquid bond markets in the Eurozone, and ordinarily traders should be able to get prices for these easily.
Eurozone faces another major crisis of confidence
Wilson thinks that Eurozone break up risks are higher but they remain small overall. If snap elections produce a clearer mandate for the populists, and they again succeed in forming a government, Italy could well be set on a collision course with the rest of European Union. EU and current Eurozone rules are far too inflexible to handle radical domestic policy shifts – it is unlikely that a new Italian government would be able to force the rules makers in Brussels to back down. This then raises the prospect of a potential Italian departure from the EU.