In an otherwise calm market, Italian bonds have been sold off today, breaking away from the broader bullish sentiment amid the European bond market, with the yield on 10Y BTPs rising as much as 5bps, above 2% for the first time since October 26.
While there has been no specific catalyst, some traders are starting to factor in the potential political confusion that could result after the Italian elections due in just over 2 months. As a reminder, on March 4, voters in eurozone’s third-largest economy will head to the polls amid dwindling support for the ruling pro-EU centre-left Democratic party and rising support for the Eurosceptic opposition.
According to the FT, the likely scenarios after the vote range include a hung parliament, a grand coalition or a populist government with a much more confrontational attitude towards Brussels, including the most troubling outcome: plans to question Italy’s membership of the single currency.
As the FT correctly points out, "None of the outcomes heralds greater stability for a country that, from an economic and financial point of view, remains the weak link in the 28-member bloc."
The biggest flashpoints in the race are expected to be Italy’s lacklustre economy and the migration crisis, which has brought more than 620,000 asylum seekers to the country from across the Mediterranean Sea over the past four years.
But analysts say the political wrangling so far has been focused more on the personalities of the party leaders than the huge challenges facing Italy.
“For the moment it’s looking like a very ugly and chaotic campaign,” says Giovanni Orsina, a professor of political science at Luiss university in Rome. “It’s concentrated on personal attacks, provocations and jokes that have nothing to do with real platforms.”
In an attempt to mitigate concerns, Citigroup recently wrote that its economists see a centre-right victory as marginally the most likely outcome, but concede that longer-term, big question marks remain over which individual party will dominate within the bloc and the true depth of ostensible EU-scepticism.
And while a grand coalition over the middle also remains a possibility, albeit a fading one, with the M5S still gaining in many polls at the expense of a struggling PD, their involvement in a future coalition of the left remains a reasonable probability. Although M5S has certainly shifted its stance on the EU significantly, with its candidate for PM declaring he wants to stay in the EU and toning down his party’s opposition to the euro, other of their desired reforms would likely be seen as negative by the market. A less likely coalition between M5S and a party on the right, like Lega Nord, could potentially be more confrontational and even less market-friendly.
Politics aside, there could be a far bigger problem for BTP demand in the coming months: the reason - uncertainty and the expected reduction in ECB purchases.
And here is a startling observation from Citi, which notes that one could argue that private investors fell out of love with BTPs quite some time ago.
As illustrated in the chart below, just about every other major investor type has become a net seller (to the ECB) or a non-buyer of BTPs over the last couple of years. Said differently, for well over a year, the only marginal buyer of Italian bonds has been the ECB!
To change that behaviour, Citi thinks it is pretty likely that there will need to be an adjustment in prices. And some other thoughts on what a decline in ECB purchases may mean for the price of BTPs:
As our rates strategists have pointed out, the ECB could counteract this through an “Italian Operation Twist” (lengthening the maturity of their BTP holdings), but such a response might not come immediately, given the ECB’s reluctance to favour individual countries, unless associated with the conditionality that comes with an economic adjustment programme.
To our minds, this remains one of the most significant political risks to € credit in 2018. Most likely the spillover on credit would be concentrated on Italian and other periphery names, banks in particular. The scenario of a full-on funding crisis is a much lower probability in our view, but would obviously have more systemic implications across the € credit market.
Translation: with the investing community having largely forgotten about Italian bonds in the past 3 years since the launch of the ECB's QE, for an advance warning whether Europe's period of artificial stability is finally starting to unravel - as many expect once the ECB begins tapering - look no further than BTP yields, and specifically if today's unexpectedly selloff persists into the new year and certainly if it accelerates.