Today's stunning comeback by Berlusconi, which is really a slide in support for Bersani and Monti whose joint coalition government is unlikely to have the 158 seats needed in the Senate to avoid elections in a few months, means the "Plan B" aka "worst" outcome is in play. How "worst"? In a note released over the weekend, JPM strategist Gianluca Salford attributed a tiny 15-20% probability to an outcome that now appears to be the base case. A far more likely result (defined by JPM as 75%) would have been a continuation of the status quo, which saw an easily-formed Center Left government. As of this moment, that no longer appears feasible. So as the next steps play out, the fulcrum security will be Italian BTPs, which according to JPM will be whacked to the tune of 40 to 100 bps (at least to start), and with deleveraging feedback loops picking up after, who knows where this will end, especially in a worst-er case scenario where there will be months of political and social uncertainty in Italy.
In our baseline scenario (75% probability), a centre-left plus centre government with a solid majority in both houses is likely to push 10Y BTPs to the 4.00% area (Exhibit 1), in the following days. In the baseline scenario, the most important variables to watch are the strength of the combined majority and the balance of power between centre-left and centre. We believe that the strength of the majority will be a market positive, whereas, based on our estimates, Monti’s limited political appeal is unlikely to boost market sentiment.
In the case of an outright centre-left majority in both Houses with the explicit refusal to enlarge the coalition to Monti’s centre (5% probability), we expect little change compared to current levels. The failure by the centre-left (even with the support of the centre) to reach a majority of seats in the Senate (5% probability) would force tortuous negotiations to extend the majority to other parties and would not be welcome by financial markets, pushing yields, at least initially, up around 40bp.
The most negative outcome (15% probability) would be a centre-right victory in the Chamber due to the political uncertainty related to the need to forge a majority in the Senate. We expect discussions between the centre-right and centre to be complex and, in addition, we see a high risk that the coalition would have to be extended to the centre-left. The initial reaction might be in the order of up to 100bp, although we expect pressure from the President of the Republic and from financial markets to eventually lead to the creation of another Grand Coalition. We expect 10Y Bunds to move with a beta of roughly -0.25 to changes in BTP yields. Weighting the scenario, the direction is for a modest decline in BTP yields and a touch higher Bund yields, but we reiterate that we do not see much value in prepositioning.
In retrospect, perhaps one should have "prepositioned."