Chaos has returned to Italy and, appropriately, it has once again started with the bad boy of Italian politics, Silvio Berlusconi, the same flamboyant playboy-cum-former prime minister who back in 2011 nearly withdrew Italy from the Eurozone and only a flagrant political intervention by the ECB prevented the collapse of the European experiment.
As we reported yesterday, in a statement published late on Wednesday night in Italy, Berlusconi changed his long-standing position, and said he'd be open to an agreement between the League and the Five-Star Movement (otherwise known as M5S) to form a ruling coalition that wouldn't include his center-right party, Forza Italia. And so, with his blessing, on Thursday the anti-establishment Five Star Movement and the far-right League were on the verge of forming a Eurosceptic government in which Europe's third largest economy would be the latest to succumb to the populist wave unleashed by a decade of central bank errors and record income and wealth disparity.
The two leaders wasted no time, and Luigi Di Maio, the Five Star leader, and Matteo Salvini, the League leader, promptly met to try to iron out details of a potential agreement, including who become next prime minister. Key cabinet positions, including the finance ministry and foreign ministry, were also being discussed according to the FT.
In a joint statement after meeting on Thursday, Di Maio and Salvini described a “positive climate to define the government’s agenda and priorities” and said “technical” meetings among staff would begin in the afternoon. "In terms of the composition of the executive, and the premier, significant steps forward were taken amid constructive collaboration on all sides, with the aim of quickly giving an answer and a political government to the country," they said.
To be sure, the two had held infrequent talks for the past few weeks, with no concrete outcomes decided due to the veto power bestowed upon Bunga Bunga; however with the Berlusconi blessing, the probability of a government becomes a virtual certainty. The reason: the 81-year-old Berlusconi had previously ruled out offering his support to a Five Star-League government unless his party was fully represented in the executive. At the same time, Five Star had vowed not to govern with Mr Berlusconi’s Forza Italia party, seeing it as part of the traditional political class it has been trying to unseat. This changed on Wednesday night when as we reported, the octogenrian playboy gave an green light to a deal, saying that while Forza Italia would vote against a Five Star-League government in parliament, this would not jeopardise his alliance with Mr Salvini on a local and regional level, where they rely on each other in many municipal and regional councils.
“If a centre-right political force takes on the responsibility of creating a government with Five Star we note that with respect,” Mr Berlusconi said in a tweet. “We will evaluate the government that is created, supporting any measures that are useful for Italians.”
Meanwhile, as we have previously reported, an alliance between Five Star and the League has long been considered the most destabilising outcome of the election because both parties have attacked EU fiscal rules, banking regulations, trade deals and sanctions against Russia. The parties were the winners of the March poll but their gains were not decisive enough to allow either to govern single-handedly, however combined they garnered more than half of the vote as Italy's legacy political power, the Democratic Party suffered a spectacular collapse.
Of course, nothing is certain, and should talks between Five Star and the League fail to reach an agreement by Sunday, Italy's president Mattarella is expected to proceed to nominating a technicratic caretaker administration, replacing the incumbent centre-left government led by Paolo Gentiloni, until the next elections are held.
As the FT adds, in a speech at the European University Institute in Florence on Thursday, Mattarella issued a thinly veiled warning to Five Star and the League not to tear up Rome’s longstanding and deep ties with the EU, which have frayed amid discontent with Brussels over economic policies and migration in recent years.
“To believe one can go it alone is pure illusion, or even worse, a wilful hoax against public opinion,” Mr Mattarella said. “Everyone knows that none of the great challenges facing our continent can be tackled by any single member state, on its own.”
To be sure, markets reflected this new risk and on Thursday, Italy's 10Y bond yield jumped as much as 1.95% before retracing modestly.
Italian stocks likewise sank on the news, with Italy's FTSE MIB the worst performing market in Europe today.
On Thursday morning Goldman also noticed, and in a note by the firm's European analyst Sylvia Ardagna, Goldman writes that "Italy's political risk increases, and yet the markets remain complacent"
The market reaction has remained remarkably muted. We think the market is complacent in pricing political risk in Italy. In our opinion, a Five Star – Lega government remains the outcome that would likely be viewed as the most negative by the market.
Goldman adds that if the Five Star – Lega attempt to form a government succeeds, "this coalition will have been the least expected outcome going into the the elections. But, in our opinion, this was and remains the outcome that would likely be viewed as the most negative by the market."
The paradox here, at least according to Goldman, is that markets continue to remain complacent even as the worst case outcome is now a virtual certainty:
Since the general election took place on March 4, news around political developments have been incrementally negative, but the market has remained complacent in pricing political risk in Italy. So far, the market reaction has remained remarkably muted even though the prospect of a Five Star – Lega government has increased. As our strategists have pointed out, carry considerations are being balanced against political risk.
From an economic perspective, however, if the political manifestos of the two parties are any guide to the policies that a Five Star – Lega government would pursue, the upcoming budget law for 2019 would consist of lax fiscal policies that would (i) lead to the deterioration of the public finance outlook and prevent a decline of the stock of public debt, and (ii) increase the probability of ratings downgrades.
Moreover, if lax fiscal policies were to be pursued, leading Italy to breach the 3% deficit rule, these policies would create tensions with the European Union and be a source of disagreement with the European Commission. Even if Five Star and Lega have toned down their anti-European rhetoric, tensions between Italy and European partners would also certainly complicate the efforts at the EU level to make further progress on EMU integration.
There is a much simpler reason for the "market complacency" - as we first explained in December, while the broader market has been dumping Italian bonds, the ECB has been buying them up. Non-stop.
As we showed late last year, 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!
As Citi said at the time looking at the future of Italian bonds, it is "pretty likely that there will need to be an adjustment in prices" once the the ECB's purchases of Italian bonds start to fade. Here Citi provided one suggestion how it may counteract an explosive selloff:
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.
Meanwhile, the risks are rising exponentially. Quote Citi:
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.
And a governing coalition between the Five Star and the League is all that would take to launch the first steps of this funding crisis. The only question is when will the market react accordintly.